Question

MHM wants to diversify its operations. The stock price is $22 a share with 225,000 shares outstanding. Total assets are $7.2 million, total liabilities are $3.8 million, and net income is $425,000. The company is considering an investment that has the same PE ratio as the current company. The cost of the investment is $360,000 which will be financed with a new equity issue. What would the ROE on the investment have to be if we wanted the stock price to remain constant?

Answer 1

Company's current stock price(P0) = 22

No of share N = 225000

Net income E = 425000$

Earnings per share EPS = 425000/225000= 1.8888...

P/E ratio= P0/EPS = 22/1.8888 = 11.6476

Cost of new investment = 360000$ wich will be financed by fresh equity issue since the price would remain unchanged i.e.22 ,the no. Of share to be issued = 360000/22 = 16363.6363$

Now since we want the same PE ratio with same price then our EPS have to be remain unchanged like

PE rstio = P0/ EPS

11.6476 = 22/EPS

EPS = 1.8888....

So our earnings from new investment = new no. Of share × EPS = 1.8888...× 16363.6363 = 30909.09

ROI = earnings/ total investment =( 30909.09/360000)×100= 8.59%