Question

Sarro Shipping, Inc., expects to earn $1.2 million per year in perpetuity if it undertakes no new investment opportunities. There are 120,000 shares of stock outstanding, so earnings per share equal $10 ($1,200,000/120,000). The firm will have an opportunity at date 1 to spend $1,200,000 on a new marketing campaign. The new campaign will increase earnings in every subsequent period by $240,000 (or $ 2 per share). The firm’s discount rate is 10 percent. What is the value per share before and after deciding to accept the marketing campaign?

Answer 1

There are two cases before and after the acceptance of new project.

For value of share before acceptance of the project-

Earning per share = Earnings/Number of shares

Earning per share = $ 10 ( $ 1.2 million / 120000)

Cost of capital = 10%

Value per share( By constant earning model) = Earning per share/cost of capital

$ 10 / 0.10 = $100.

Value per share = $100

After the acceptance of the project , the eaarnings per share will be increased by $2 per share.

Earning per share = $ 12 ( original + Increase )

Cost of capital = 10%

Value per share = $12/.10

Value per share= $ 120