Concept explainers
Dilution The all-equity firm Metallica Heavy Metal Mining (MHMM) Corporation wants to diversify its operations. Some recent financial information for the company is shown here:
Stock price | $75 |
Number of shares | 65,000 |
Total assets | $9,400,000 |
Total liabilities | $4, 100,000 |
Net income | $980,000 |
MHMM is considering an investment that has the same PE ratio as the firm. The cost of the investment is $l,500,000, and it will be financed with a new equity issue. The return on the investment will equal MHMM's current
To determine: The effect on the book value per share, market value per share and the earnings per share, the net present value of the investment and do dilution takes place.
Dilution:
The dilution is a process or action, where the ownership percentage of a shareholder gets reduced due to the issue of new shares. As the number of outstanding shares gets increased, the par value of the company gets decreased.
Return on Equity:
The return on equity refers to the part of net income, where the company gets profits from the amount invested by the shareholders. The return on equity is a measure of the profitability of a company.
Earning per share:
The earning per share is a measure of the profitability of a company. It represents the portion of the profit of the company which is allocated to each outstanding share of the stock.
Explanation of Solution
Given,
The stock price is $75.
The number of shares is 65,000.
The value of total assets is $9,400,000.
The value of total liabilities is $4,100,000.
The net income is $980,000.
Calculation of the current earnings per share:
The formula to calculate the earnings per share is,
Substitute $980,000 for net income and 65,000 for outstanding shares in the above formula.
Hence, the current earnings per share are $15.08 per share.
Calculation of the new earnings per share:
The formula to calculate the new earnings per share is,
Substitute $1,257,358 for the net income and 85,000
Hence, the earnings per share is $14.79 per share.
The earnings per share decreases by $0.29
Calculation of the current book value per share:
The formula to calculate the current book value per share,
Substitute $5,300,000
The current book value per share is $81.54 per share.
Calculation of the new book value per share:
The formula to calculate the new book value per share is,
Substitute $6,800,000
Hence, the new book value per share is $80 per share.
The book value per share decreases by $1.54
Calculation of the current market-to-book ratio:
The formula to calculate the current market-to-book ratio is,
Substitute $75 for the current stock price and $81.54 for the book value per share in the above formula.
Hence, the current market-to-book ratio is $0.9198.
Calculation of the new market-to-book ratio:
The formula to calculate the new market-to-book ratio is,
Substitute $73.58 for the new share price and $80 for the new book value per share in the above formula.
Hence, the new market-to-book ratio is.$0.9198.
The new market to book ratio is same.
Calculation of the net present value:
The formula to calculate the net present value is,
Substitute $1,379,300 for the change in market value (refer working note) and $1,500,000 for the cost of project in the above formula.
Hence, the net present value of the firm is −$120,700.
As the market to book ratio is less than one, Accounting dilution takes place. Also, the firm is investing in a project whose net present value is negative, so the market dilution will take place.
Working note:
Calculation of the total equity:
Calculation of the total equity:
The total equity is $5,300,000.
Calculation of the return on equity:
Hence, the return on equity is 18.49%.
Calculation of the new net income:
Hence, the new net income is $1,257,358.
Calculation of the number of new shares:
Hence, the number of new shares is 20,000.
Calculation of the price-earnings ratio:
Hence, the price-earnings ratio is 4.974.
Calculation of the new stock price:
The formula to calculate the new stock price is,
Substitute $14.79 for the new earnings per share and 4.974 for the price-earnings (refer working note) in the above formula.
Hence, the new stock price is $73.58.
Calculation of the change in market value of firm:
Hence, the new market value is $1,379,300.
Thus, the book value per share decreases by $1.54, the earnings per share decreases by $0.29 and the market-to-book ratio remains the same. The dilution takes place as the net present value is negative.
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Chapter 20 Solutions
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