1.You are CEO of a high-growth technology firm. You plan to raise $180 million to fund an expansion by issuing either new shares or new debt. With the expansion, you expect earnings next year of $24 million. The firm currently has 10 million shares outstanding, with a price of $90 per share. Assume perfect capital markets.
a. If you raise the $180 million by selling new shares, what will the forecast for next year’s earnings per share be?
b. If you raise the $180 million by issuing new debt with an interest rate of 5%, what will the forecast for next year’s earnings per share be?
c. What is the firm’s forward P/E ratio (that is, the share price divided by the expected earnings for the coming year) if it issues equity? What is the firm’s forward P/E ratio if it issues debt? How can you explain the difference?
2.Zelnor, Inc., is an all-equity firm with 100 million shares outstanding currently trading for $8.50 per share. Suppose Zelnor decides to grant a total of 10 million new shares to employees as part of a new compensation plan. The firm argues that this new compensation plan will motivate employees and is a better strategy than giving salary bonuses because it will not cost the firm anything.
a. If the new compensation plan has no effect on the value of Zelnor’s assets, what will be the share price of the stock once this plan is implemented?
b. What is the cost of this plan for Zelnor’s investors? Why is issuing equity costly in this case?