Chapter 5: 1BP (page 494)

Louisiana Timber Company currently has 5 million shares of stock outstanding and will report earnings of $9 million in the current year. The company is considering the issuance of 1 million additional shares that will net $40 per share to the corporation.
a. What is the immediate dilution potential for this new stock issue?
b. Assume the Louisiana Timber Company can earn 11 percent on the proceeds of the stock issue in time to include it in the current year’s results. Should the new issue be undertaken based on earnings per share?

Short Answer

Expert verified

a. The dilution is $0.30.

b. Yes, the new issue should be undertaken.

Step by step solution

Computation of immediate dilution

$E P S b e f o r e s t o c k i s s u e = \frac{E a r n i n g s}{O u t s \tan d i n g s t o c k} = \frac{$ 9, 000, 000}{5, 000, 000} = $ 1.8 E P S a f t e r s t o c k i s s u e = \frac{E a r n i n g s}{O u t s \tan d i n g s t o c k + A d d i t i o n a l i s s u e} = \frac{$ 9, 000, 000}{6, 000, 000} = $ 1.5 D i l u t i o n = E P S b e f o r e s t o c k i s s u e - E P S a f t e r s t o c k i s s u e = $ 1.8 - $ 1.5 = $ 0.3$

Computation of growth in EPS

$N e w i n c o m e = E x p e c t e d e a r n i n g s (A d d i t i o n a l i s s u e \times p r i c e p e r s h a r e) = 11 % (1, 000, 000 \times $ 40) = $ 4, 400, 000 N e w E P S = \frac{T o t a l i n c o m e}{O u t s \tan d i n g s t o c k + A d d i t i o n a l i s s u e} = \frac{$ 13, 400, 000}{6, 000, 000} = $ 2.23 G r o w t h i n E P S = N e w E P S - E P S b e f o r e s t o c k i s s u e = $ 2.23 - $ 1.8 = $ 0.43$

Conclusion:Hence, the new issue should be undertaken because earnings per share will grow by $0.43.

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Assets
	Book value	Liquidation value
Accounts receivables	\(1,400,000	\)1,200,000
Inventory	\(1,800,000	\)900,000
Machinery and equipment	\(1,100,000	\)600,000
Building and plant	\(4,200,000	\)2,500,000
Total assets	\(8,500,000	\)5,200,000

Liabilities and stockholder’s claims
Liabilities
Accounts payable	\(2,800,000
First lien, secured by machinery and equipment	\)900,000
Senior unsecured debt	\(2,200,000
Subordinated debenture	\)1,700,000
Total liabilities	\(7,600,000
Stockholder’s claims
Preferred stock	\)250,000
Common stock	\(650,000
Total stockholder’s claims	\)900,000
Total liabilities and stockholder’s claims	$8,500,000

Bailey corporation
Income statement
For the year 20X1
Sales (all on credit)	\(42,680,000
Cost of goods sold	\)32,240,000
Gross profit	\(10,440,000
Selling and administrative expenses	\)4,558,000
Operating profit	\(5,882,000
Interest expense	\)600,000
Net income before taxes	\(5,282,000
Taxes	\)2,120,000
Net income	\(3,162,000

Bailey corporation
Balance sheet
As of December 31, 20X1
Assets
Current assets:
Cash	\)250,000
Marketable securities	\(130,000
Accounts receivables	\)6,000,000
Inventory	\(8,300,000
Total current assets	\)14,680,000
Net plant and equipment	\(13,970,000
Total assets	\)28,650,000
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable	\(3,800,000
Notes payable	\)3,550,000
Total current liabilities	\(7,350,000
Long-term liabilities	\)5,620,000
Total liabilities	\(12,970,000
Stockholder’s equity:
Common stock (1,800,000 shares at \)1 par)	\(1,800,000
Capital in excess of par	\)6,300,000
Retained earnings	\(7,580,000
Total stockholder’s equity	\)15,680,000
Total liabilities and stockholder’s equity	\(28,650,000

Short Answer

Step by step solution

Computation of immediate dilution

Computation of growth in EPS

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