Problem 19-11 Dilution The Metallica Heavy Metal Mining (MHMM) Corporation wants
ID: 2742507 • Letter: P
Question
Problem 19-11 Dilution The Metallica Heavy Metal Mining (MHMM) Corporation wants to diversify its operations. Some recent financial information for the company is shown here: Stock price 50 Number of shares 30,000 Total assets 8,700,000 Total liabilities 3,600,000 Net income 600,000 MHMM is considering an investment that has the same PE ratio as the firm. The cost of the investment is $640,000, and it will be financed with a new equity issue. (Do not round intermediate calculations.) The ROE on the investment would have to be percent (Round your answer to 2 decimal places (e.g., 32.16)) if we wanted the price after the offering to be $50 per share (assume PE ratio remains constant), and the NPV of the investment the certain to would be (Leave no cells blank be Market enter "0" wherever required.). Accounting dilution (click to select occur in this case. value dilution (Click to select occur in this caseExplanation / Answer
The total equity of the company is total assets minus total liabilities, or :
Equity = $8,700,000 - $3,600,000
Equity =$5,100,000
Current ROE = $600,000/5,100,000 = 0.117647
The new net income will be the ROE times the new total equity, or:
NI1= (ROE0)(TE1)
New net income = 0.117647 ($5,100,000 + $640,000) = $675294
The company’s current earnings per share are :
EPS0= NI0/Shares outstanding0
EPS0 = $600,000/30,000 shares = $20.00
The number of shares the company will offer is the cost of the investment divided by the current share price, so :
Number of new shares = $640,000/$50 = 12,800
The earnings per share after the stock offer will be :
EPS1= $675,294/42,800 shares = $15.78
The current P/E ratio is :
(P/E)0 = $50/$20 = 2.50
Assuming the P/E remains constant, the new stock price will be :
P1 = 2.50($15.78) = $39.45
The current book value per share and the new book value per share are :
BVPS0 = TE0/shares0= ($8,700,000 – $3,600,000)/30,000 shares = $170 per share
BVPS1= TE1/shares1= ($8,700,000 – $3,600,000 + 640,000)/42,800 shares = $134.11 per share
So the current and new market-to-book ratios are :
Market-to-book0 = $50/$170 = 0.2941
Market-to-book1= $39.45/$134.11 = 0.2942
The NPV of the project is the cost of the project plus the new market value of the firm minus the current market value of the firm, or:
NPV = –$640,000 + [$39.45 (42,800) – $50(30,000)]
NPV = $-451,540
Accounting dilution takes place here because the market-to-book ratio is less than one. Market value dilution has occurred since the firm is investing in a negative NPV project.