Tryiing to prepare for an exam and have gotten stumped
Stock prices $40 Market value of firm 400,000
Numbers of shares 10,000 Earnings per share $4
Book net worth 500,000 Return on investment 8%
Pisa has not performed spectaculary to date. However, it wishes to
issue new shares to obtain $80,000 to finance expansion into a
promosing market. Pisa?s financial advisers think a stock issue is a
poor choice b/c, 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 = 46,6000/12,000 = 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. |
Request for Question Clarification by
livioflores-ga
on
11 Mar 2005 18:16 PST
Hi!!
Researching for this question I found a (brief) answer at the Gary
Smith's page from the Department of Economics at Pomona College.
Since I cannot offer you further explanations I post such answer here
to put it under your consideration.
If you think that this covers your needs, please let me know and I
will post this comment in the answer box to claim the prize.
From the Old Tests section of Economics 156: Security Valuation and
Portfolio Theory at Gary Smith's page:
"Econ 126 1995 Final Examination Answers" (Problem 20, the last one):
"The conservation-of-value principle suggests that selling shares for
their market value is a nonevent.
With the infusion of $40*(2,000) = $80,000 in cash, the total market
value of the company should increase from $400,000 to $480,000
--implying a per-share market value of $480,000/12,000 = $40 as before.
If, however, they use the proceeds to make a crummy investment, the
market price will decline. The value of Tobin's q for existing assets
is:
q = 400,000/500,000 = 0.8
If the $80,000 in new cash is invested similarly and valued by the
market similarly, then its market value will be 0.8*($80,000) =
$64,000 --implying a per share price of $464,000/12,000 = $38.67, as
in the exercise. Thus it is not the sale of additional shares of stock
that depresses the stock's price; it is the investment of this money
in insufficiently profitable ventures."
http://www.economics.pomona.edu/GarySmith/Econ156/Econ126final95ans.HTML
To see the statement (problem 20):
"Econ 126 1995 Final Examination":
http://www.economics.pomona.edu/GarySmith/Econ156/Econ126final95.HTML
Hope that this helps you.
I will wait for your response to this comment.
Regards.
livioflores-ga
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