Chapter 15, Problem 22PS

Dilution Here is recent financial data on Pisa Construction Inc.

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 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 does not change. Then

$\begin{array}{c}\text{Book net worth}=\$580,000\\ \text{Total earnings}=.08(580,000)=\$46,400\\ \text{Earnings per share}=\frac{46,400}{12,000}=\$3.87\end{array}$

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.