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FIN/554 class:

1. Brealey, Chapter 15, page 429, Challenge Question 3

Here is recent financial data on Pisa Construction.
Stock Price: \$40 Market value of firm: \$400,000
# 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 to obtain \$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 doesn't change. Then
Book net worth = \$580,000
Total earnings = .08(580,000) = \$46,400
Earnings per share = 46,400/12,000 = \$3.87
Thus, EPS declines, book value per share declines, and share price will decline proportionately to \$38.70"

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

2. Brealey, Chapter 15, page 429, Challenge Question 4

Do you think that there could be a shortage of finance for new ventures? Should the government help to provide such finance and, if so, how?

#### Solution Preview

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1. Brealey, Chapter 15, page 429, Challenge Question 3

Here is recent financial data on Pisa Construction.
Stock Price: \$40 Market value of firm: \$400,000
# 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 to obtain \$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 doesn't change. ...

#### Solution Summary

This post answers two challenge questions which help to understand the assumptions implicit and government's riole in venture capital funding.

\$2.49