The Metallica Heavy Metal Mining (MHMM) Corporation wants to diversify its opera

Question

The Metallica Heavy Metal Mining (MHMM) Corporation wants to diversify its operations. Some recent financial information for the company is shown here:

MHMM is considering an investment that has the same PE ratio as the firm. The cost of the investment is $800,000, and it will be financed with a new equity issue. The return on the investment will equal MHMM

The Metallica Heavy Metal Mining (MHMM) Corporation wants to diversify its operations. Some recent financial information for the company is shown here:

Explanation / Answer

Current:

EPS = (Net after tax Income - Preference dividend)/number of equity shares = 440000 / 40000 = $11

PE ratio = Market price per share / EPS = 73 / 11 = 6.64

ROE = (Net Income after tax - preference dividend) / Net Worth OR Shereholders' Equity = 440000 / (Total Assets - Fictitious Assets - Total outside liabilities) = 440000 / (7600000 - 2200000) = 440000 / 5400000 = 8.15 %

Book Value Per Share = (Shareholders' Equity - Preference Capital) / number of equity shares = [(7600000 - 2200000) - 0] / 40000 = $135

New Investment = $ 800000

Return on investment = ROE of the existing project = 8.15%

=> Net return from the new project = 800000 x 8.15% = $65200

Assuming that the firsm has issued the equity for the new project at mrket price, the number of equity shares issued to finance the new project = 800000/73 = 10959 shares

Total number of equity shares after the new issue = 40000 + 10959 = 50959

Assuming the total assets and the total liability of the firm remains same after the nes issue, the net worth of the firm will increase by the net earning from the new project . Therefore, new net worth of the firm = (7600000 - 2200000) + 65200 = $5465200

New Book Value per share = 5465200 / 50959 = $ 107.24

So,

current book value per share = $ 135

new book value per share = $ 107.24

Current Market to Book Value = Market Value of share / book value of share = $73/$135 = 0.54

New Market to Book Value = 73 / 107.24 = 0.68

Current Earnings Per Share = Net income before the new project / number of shares outstanding = 440000/40000 = $11

New Earning per share = (440000 +62500) / (40000 + 10959) = $9.86

NPV of the investment:

Assuming that the return is generated at the end of 1 year after the initial investment,

PV of cash outflow = $800000

PV of cash inflow = $ 800000 + $62500*[1/(1+.0815) = $857790

NPV = $ 857790 - $800000 = $57990

(the cash inflow frm the issue of equity share has been occurred at the beginning ofthe year whe the investment was made)

Accounting Dilution occurs as the EPS gets depressed

There is no dilution in the Market Value of the share

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