Question

Question: The Bailey Corporation, a manufacturer of medical supplies and equipment, is planning to sell its shares to the general public for the first time. The firm’s investment banker, Robert Merrill and Company, is working with Bailey Corporation in determining a number of items. Information on the Bailey Corporation follows:

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

f. What return must the corporation now earn on the net proceeds to equal earnings per share before the offering? How does this compare with current return on the total assets on the balance sheet?

Short answer

Answer

The rate of return that the corporation must earn is 11.33% and this rate of return is more than the company’s return on assets.

Step-by-step solution

Information provided in the question

Shares issued to public = 400,000 shares

Shares outstanding = 1,800,000

Out-of-pocket costs = $300,000

PE ratio = 12 times

EPS =$1.44

Initial market price of shares = $17.28

Proceeds from issue of shares = $6,266,400

Calculation of earnings per share before issue

The earnings per share before issue is $1.76.

$$\begin{gathered} \mathrm{EPS}=\frac{\mathrm{Earnings}}{\mathrm{Number}\mathrm{of}\mathrm{shares}\mathrm{outstanding}} \\ =\frac{\$3,162,000}{1,800,000} \\ =\$1.76 \end{gathered}$$

Calculation of new earnings required to maintain earnings per share before issue

The rate of return required is $710,000.

We have assumed the new earnings to be X.

$$\begin{gathered} \mathrm{EPS}=\frac{\mathrm{Earnings}+\mathrm{X}}{\mathrm{Number}\mathrm{of}\mathrm{shares}\mathrm{oustanding}+\mathrm{New}\mathrm{issue}} \\ \$1.76=\frac{\$3,162,000+\mathrm{X}}{1,800,000+400,000} \\ \$1.76\times 2,200,000=\$3,162,000+\mathrm{X} \\ \mathrm{X}=3,872,000-\$3,162,000 \\ \mathrm{X}=\$710,000 \end{gathered}$$

$$\begin{gathered} \mathrm{EPS}=\frac{\mathrm{Earnings}+\mathrm{New}\mathrm{earnings}}{\mathrm{Number}\mathrm{of}\mathrm{shares}\mathrm{outstanding}+\mathrm{New}\mathrm{issue}} \\ =\frac{\$3,162,000+710,000}{1,800,000+400,000} \\ =\frac{3,872,000}{2,200,000} \\ =\$1.76 \end{gathered}$$

Calculation of return to be generated to maintain earnings per share before issue

The rate of return required is $11.33%.

$$\begin{gathered} \mathrm{Rate}\mathrm{of}\mathrm{return}=\frac{\mathrm{New}\mathrm{earnings}}{\mathrm{New}\mathrm{proceeds}} \\ =\frac{\$710,000}{6,266,400} \\ =11.33\% \end{gathered}$$

Calculation of return on assets

The return on assets is 11.04%.

$$\begin{gathered} \mathrm{Return}\mathrm{on}\mathrm{assets}=\frac{\mathrm{Net}\mathrm{income}}{\mathrm{Total}\mathrm{assets}} \\ =\frac{\$3,162,000}{\$28,650,000} \\ =11.04\% \end{gathered}$$

Comparison between the return the corporation must earn and the current return on assets.

The return on assets is 11.04% and the required return rate is 11.33% which is more than the return on assets. The return on assets is lower as compared to the rate of return on net proceeds that the company is required to maintain.