Evaluate this argument with particular attention to the assumptions implicit in the numerical example.?

Question

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 stick 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 examples: "Suppose 2,500 new shares are issued at $40 and the proceeds are invested. (Neglect issue costs).

Answer 1

The market value of the firm is initially $400,000. If the firm issues 2,500 new shares at $40 per share, then it raises $100,000 in new capital. This makes the market value of the firm rise to $500,000.

There are now 12,500 shares or claims on the firm, which means that each share is worth 500,000/12,500 = $40.

So, the fundamentals have not changed. The book value is not really important. It's the market value that matters.

There is an important assumption being made, though, that is worth thinking about. Current earnings are $4 per share, which is what determines the market value. If the firm really is able to issue new shares at $40 per share, then the new investors must be thinking that the firm can produce $4 per share in earnings on the new capital, too.

Answer 2

It will dilute the company by 25% and the stock price should drop to @$30.