Financing a new project with new equity will reduce earnings

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Reference no: EM13215157

During recent years your company has made considerable use of debt ?nancing, to the extent that it is generally agreed that the percent debt in the ?rm's capital structure is too high. Further use of debt will likely lead to a drop in the ?rm's bond rating. You would like to recommend that the next major investment be ?nanced with a new equity issue. Unfortunately, the ?rm 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 pro?table project will decrease earnings per share if it is ?nanced with new equity. For example, the ?rm 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 ?nanced 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 ?rm argues that the project should be delayed for three reasons.

a) It is too expensive for the ?rm 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 ?rm waits until the market index improves, the market value of equity will exceed the book value and equity ?nancing will no longer reduce earnings per share.

Reference no: EM13215157

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