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Effect on Stock Price

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Here is recent financial data on Pisa Construction Inc
Stock price $ 40 market
Number of shares 10,000
Earnings per share $4
value of firm $400,000
Book net worth $500,000
ROI 2% quaterly
Pisa Construction has not performed spectacularly to date, however it wishes to issue new shares to obtain $100,000 to finance expansion into a promising market.
Pisa's financial advisers think a stock at a price below book value per share can only depress the stock price and decrease the shareholders'wealth.
To prove the point they construct the following example: "suppose 2,500 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=$600,000. total earnings=.0824(600,000)= $49,440. Thus, EPS declines, book value per share declines and share price will decline proportionately to $38.40.

Evaluate this argument with particular attention to the assumptions implicit in the numerical example.

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Solution Summary

The solution explains the effect on stock price of issuance of new shares and investing in a project.

Solution Preview

If we look at the figures supplied, the EPS is $4 and the share price is $40. This implies that the expected return of the shareholders is 10%. $40 being the present value of a perpetuity of $4. From the new issue, the ROI is given as 8%. This would imply that the project is not an NPV positive project, since the expected return is 10%. The project amount is 100,000 ...

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