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Pisa Construction - Investing in a Negative NPV Project

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.


Solution Preview

See the attached file for complete solution. The text here may not be copied exactly as some of the symbols / tables may not print. Thanks

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 ...

Solution Summary

This posting evaluates an argument about issuing new shares below the book value. It tries to trace the implicit assumptions in the problem and whether the argument raised in the question is sustainable or not. What will happen to the share price of the company if company still takes up this project but raises the capital through some other means. The post clarifies the confusing concepts about the market value of the company. This solution is provided in an attached Word document.