Chapter 5: 3BP (page 495)

American Health Systems currently has 6,400,000 shares of stock outstanding and will report earnings of $10 million in the current year. The company is considering the issuance of 1,700,000 additional shares that will net $30 per share to the corporation.
a. What is the immediate dilution potential for this new stock issue?
b. Assume that American Health Systems can earn 9 percent on the proceeds of the stock issue in time to include them in the current year’s results. Calculate earnings per share. Should the new issue be undertaken based on earnings per share?

Short Answer

Expert verified

a. Immediate dilution is $0.328.

b. New EPS is $1.8012 and the new issue should be undertaken.

Step by step solution

Computation of immediate dilution

$E P S b e f o r e s t o c k i s s u e = \frac{E a r n i n g s}{O u t s \tan d i n g s t o c k} = \frac{$ 10, 000, 000}{6, 400, 000} = $ 1.5625 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{$ 10, 000, 000}{6, 400, 000 + 1, 700, 000} = \frac{$ 10, 000, 000}{8, 100, 000} = $ 1.2345 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 = $ 1.5625 - $ 1.2345 = $ 0.328$

Computation of New 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) = 9 % (1, 700, 000 \times $ 30) = 9 % (51, 000, 000) = $ 4, 590, 000 T o t a l i n c o m e = N e w i n c o m e + R e p o r t e d e a r n i n g s = $ 4, 590, 000 + $ 10, 000, 000 = $ 14, 590, 000 N e w E P S = \frac{T o t a l i n c o m e}{N u m b e r o f s h a r e s} = \frac{$ 14, 590, 000}{8, 100, 000} = $ 1.8012$

Undertaking of new issue

$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 = $ 1.8012 - $ 1.5625 = $ 0.2387$

The new issue should be undertaken because there will be no dilution and EPS will grow by $0.2387.

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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

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

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

Short Answer

Step by step solution

Computation of immediate dilution

Computation of New EPS

Undertaking of new issue

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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