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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Computation of immediate dilution

Computation of growth in EPS

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