Here is the 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           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 th 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 does not 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.

Jaemarie --

The "book net worth" may -- or may not represent real value to the
firm.  Imagine a change in depreciation rules by the government,
allowing accelerated depreciation of assets.  Or simply an IRS ruling
that the company's depreciating those assets wrong.  Or the assets not
being useful because of changes in the market.

There's a real-world example of book net worth in what Sprint did in
2004, when it wrote down $3.54 billion in assets related to its
long-distance business because of changes in technology:
http://answers.google.com/answers/threadview?id=567424 

This company is returning 10% ($40,000 on the $400,000 market value)
and should have a hurdle rate for the new investment that makes sure
shareholders are getting that level of return PLUS a risk adjustment
(per the Capital-Asset Pricing Model).

Best regards,

Omnivorous-GA