MHM wants to diversify its operations. The stock price is $22 a share with 225,000 shares outstanding. Total assets are $7.2 million, total liabilities are $3.8 million, and net income is $425,000. The company is considering an investment that has the same PE ratio as the current company. The cost of the investment is $360,000 which will be financed with a new equity issue. What would the ROE on the investment have to be if we wanted the stock price to remain constant?

Question

Quizplus · Accepted Answer

To keep the stock price constant, the new investment must maintain the current PE ratio. The current PE ratio is calculated as (Stock Price / Earnings per Share) = $22 / ($425,000 / 225,000) = 11.65. The new investment must generate enough earnings to maintain this ratio. The required earnings from the new investment are $360,000 / 11.65 = $30,900. The ROE on the investment is then $30,900 / $360,000 = 8.59%.

MHM Wants to Diversify Its Operations