Question

Midland Corporation has a net income of $15 million and 6 million shares outstanding. Its common stock is currently selling for $40 per share. Midland plans to sell common stock to set up a major new production facility with a net cost of $21,660,000. The production facility will not produce a profit for one year, and then it is expected to earn a 15 percent return on the investment. Wood and Gundy, an investment dealer, plans to sell the issue to the public for $38 per share, with a spread of 5 percent.

a.How many shares of stock must be sold to net $21,660,000? (Note: No out-of-pocket costs must be considered in this problem.)

b.Why is the investment dealer selling the stock at less than its current market price? What are the EPS and the P/E ratio before the issue (based on a stock price of $40)?

c.What will be the price per share immediately after the sale of stock if the P/E stays constant? (based on including the additional shares computed in part a).

d.Compute the EPS and the price (P/E stays constant) after the new production facility begins to produce a profit.

e.Are the shareholders better off because of the sale of stock and the resultant investment? What other financing strategy could the company have tried to increase EPS?

Answer 1

Solution:
Given:
Net income	$15 Million
No of shares outstanding	6 Million shares
Common stock S.P.	$40 Per share
Net cost	$21,660,000
Return on investment	15%
Public issue price	$38 Per share
Spread	5%
a)
Net amount to be raised	$21,660,000
We will first calculate the net price to the corporation:
Public price	$ 38 Per share
Less: Spread @ 5%	$-1.9 Per share	($38*5%)
Net Price to the corporation	$36.1 Per share
Therefore no of shares to be sold:
No of shares to be sold= Net amount to be raised/Net price to the corporation
$21,660,000/$36.10
600000
No of shares to be sold = 600000 shares
b)
The new shares would increase the total number of shares outstanding and dilute the EPS.
The dilution effect would reduce the stock price in the market .By selling at below market value,the
investment banker is attempting to attract investors into dilutive situtation.Investment banker is
reducing its underwriting risk by pricing the issue at the a loer price.
Calculation of EPS
EPS = Net Income/No of shares to be sold
$15,000,000/6,000,000
2.5
EPS = $2.5
Calculation of PE Ratio:
P/E Ratio = Stock Price/EPS
$40/$2.5
16
PE Ratio = 16 Times
c)
Price immediately after the sale of stock:
Price = Net income/(No of shares outstanding +No of shares to be sold)
$15000000/(6000000+600000)
$15000000/(6600000)
2.272727273
EPS After offering = $2.27
d)
Total Net Income = Net income + (Net amount to be raised *Rate of return)
$15,000,000 +($21,660,000*15%)
$18249000
Net Income = $18,249,000
EPS After contribution = Net income/Total no of shares
$18,249,000/6,600,000
2.765
EPS = $2.77
Price after contribution = P/E /EPS
16*$2.765
44.24
Therefore price = $44.24
e)
The company is better off because of its additional investment.Earnings per share are
$0.27 ($2.77-$2.50) higher and stock price has also increased.If Firm had sued debt financing or combination
of debt and stock, they would have increased EPS more, which would have resulted in additional
financial obligation.