Question

A company needs $35,943,750 to finance a major project in the company. The company expects that next year’s earnings from current operations and the additional earnings from the new project will be a total of $45,650,000. The company currently has 5,075,000 shares outstanding, with a price of $17.75 per share. The company’s management is assuming that any the additional shares issued to finance the project will not affect the market price of the company’s common stock.

Calculate the following:

If the $35,943,750 needed for the project is raised by selling new shares, what will the forecast for next year’s earnings per share (EPS) be?

If the $35,943,750 needed for the project is raised by selling new shares, what will the firm’s price earnings ratio (PE ratio) be?

If the $35,943,750 needed for the project is raised by issuing new debt, what will the forecast for next year’s earnings per share be? (Assume that there is no “tax shield effect” with issuing corporate debt.)

If the $35,943,750 needed for the project is raised by issuing new debt, what will the firm’s PE ratio be?

Answer 1

a) If funds needed are raised by selling new shares -

No. of new shares to be issued = $35943750 / $17.75 per share = 2,025,000 shares

Total no. of shares = 5,075,000 + 2,025,000 = 7,100,000 shares

EPS = Earnings / Total no. of shares = $45,650,000 / 7,100,000 shares = $6.43 per share

b) P/E ratio = Price per share / EPS = $17.75 / $6.43 = 2.76 times

c) In case debt is issued the total shares will remain the same, i.e, 5,075,000 shares. Also, since their is no tax shield effect of debt, the earnings will remain the same.

EPS = $45,650,000 / 5,075,000 shares = $8.99 or $9

d) P/E ratio = $17.75 / $9 = 1.97 times