Financial data for Pisa Construction, Inc.  Stock Pric-$40, Number of
Shares 10,000, Book Net Worth $500,000, Market value of firm $400,000,
Earnings per share $4, and 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 promising market. Pisa's
financial advisers think a stock issue is a poor choice because, among
other reaons, "sale of stock at a price below book value per share can
only depress the stock price and decrease shareholder's wealth." To
prove the point they construct the following example. "Suppose 2,000
new shares are issued at $0 and the proceeds are invested (Neglect
issue costs) Suppose return on investment doesn't change.  Then Book
Net Worth = $580,000, Total Earings = .08(580,000) = $46,400 and
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.

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Request for Question Clarification by livioflores-ga on 17 Apr 2005 19:20 PDT

Hi!!

I have not enough fiancial skills to do this problem, but researching
for learning how to do it I found the (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 the answer in
this requesting box.
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


I will wait for your response to this comment.

Regards.
livioflores-ga

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Clarification of Question by lola5-ga on 18 Apr 2005 18:38 PDT

The answer is okay.

Hi lola5!!


Thank you for giving me the opportunity to answer your question.

So here is the answer:

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


As you can see by yourself, the old exam's answers give you a good
backup of examples in many different and interesting problems on
topics related to this one. I hope that the page provide you a lot of
help in your studies.

Best regards.
livioflores-ga