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.© BrainMass Inc. brainmass.com March 4, 2021, 6:23 pm ad1c9bdddf
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 ...
The solutions evaluates the effect of new issue of shares on EPS, book value and share price