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    Pisa Construction: Evaluation of new issue of shares

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    Could someone please help me evaluate this argument with particular attention to the assumptions implicit in the numerical example?

    Here is recent financial data on Pisa Construction, Inc.

    Stock price $40 Market value of firm $400,000
    Number of shares 10,000 Earnings per share $4
    Book net worth $500,000 Return on investment 8%

    Pisa has not performed spectacularly to date. However, it wishes to issue new shares toobtain $80,000 to finance expansion into a promising market. Pisa's financial advisers think a stock issue is a poor choice because, among other reasons, "sale of stock at a price below book value per share can only depress the stock price and decrease shareholders' wealth." To prove the point they construct the following example: "Suppose 2,000 new shares are issued at $40 and the proceeds are invested. (Neglect issue costs.)

    Suppose return on investment does not change. Then
    Book net worth = $580,000
    Total earnings =.08(580,000) = $46,400

    Earnings per share 46,400 = $3.87

    Thus, EPS declines, book value per share declines, and share price will decline proportionately to $38.70.

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    Solution Preview

    Stock price $40
    Number of shares 10,000
    Earnings per share $4
    Market value of firm $400,000

    Return on investment= 10% =$4./$40.
    Return on investment should be calculated on market value and not on the book value
    Thus return on investment is 10% and not 8%

    Original investment = Mkt value of the ...

    Solution Summary

    The solutions evaluates the effect of new issue of shares on EPS, book value and share price