Does the Financial Data Suggest a Decline?
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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 2% quarterly
Pisa 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 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 2,500 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
In about 235 words, this solution presents an example of how to approach this problem which is analyzing financial data, including various measures such as NPV and share price, to evaluate whether a particular decline is likely. Any required calculations are provided with the solution.
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Solution:
Pisa Construction’s return on investment is 8.24%, whereas investors require a 10% rate of return.
- Total earnings to shareholders/Share price = 4/40 = 10%
Pisa proposes a scenario in which 2,500 shares of common stock are issued at $40 per share, and the proceeds ($100,000) are then invested at 8.24%. If the proceeds are invested ...
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