29. Dilution (S14.3) Here is 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 the stock price and decrease shareholders’

wealth.” To prove the point they construct the following example:

Chapter 14 How Corporations Issue Securities 429

“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

=

0.08 (580,000) = $46,400 Earnings per share

=

_ 4_6_,4_0_0_ 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.