During recent years your company has made considerable use of debt financing, to

Question

During recent years your company has made considerable use of debt financing, to the extent that it is generally agreed that the percent debt in the firms capital structure is too high. Further use of debt will likely lead to a drop in the firms bond rating. You would like to recommend that the next major investment be financed with a new equity issue. Unfortunately, the firm has not been doing very well recently (nor has the market). In fact, the rate of return on investment has just been equal to the cost of capital. As shown below, the market value of equity is less than book value. Total market value of equity $ 2,000 Number of shares outstanding 1,000 Price per share $ 2.00 Book value per share $ 4.00 Total earnings for the year $ 600 Earnings per share $ .60 This means that even a profitable project will decrease earnings per share if it is financed with new equity. For example, the firm is considering a project which costs $400 but has a value of $500 (i.e. an NPV of 100), and which will increase total earnings by $60 per year. If it is financed with equity, the $400 will require approximately 200 shares, thus bringing the total shares outstanding to 1200. The new earnings will be $660, and earnings per share will fall to $.55. The president of the firm argues that the project should be delayed for three reasons. a) It is too expensive for the firm to issue new debt. b) Financing the project with new equity will reduce earnings per share because the market value of equity is less than book value. c) Equity markets are currently depressed. If the firm waits until the market index improves, the market value of equity will exceed the book value and equity financing will no longer reduce earnings per share. Critique the presidents logic.

Explanation / Answer

Answer:

b) The example taken by the president is not valid as the profit and NPv taken is $100 therefore as the NPV increase the EPs would also increase and as the cost decrease the EPS would increase therefore it is mere assumption

a) the firm debt interest rate if it is more than the cost of equity then the firm has expensive debt otherwise it is cheaper

c) Increase in EPs has no relevance for increase in market value because EPS = Profit after tax /No of shares and nowhere we are using the market value of the shares therefore the President logic is not reasonable and tenable.

ROI = Ko MKT value = mkt price * mkt share $2*1000 2000 Whereas the book value = $4.00 per share Therefore the book value = 4000 Total earning = $600 EPS = $.60 Therefore no of shares outstanding would be 1000

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