In: Finance
During this week’s (Unit 7) Written Assignment, we found that when additional shares of stock are issued, the earnings per share decreases (assuming no change in total earnings). For your Learning Journal, in at least three well composed paragraphs, please explain how this occurs and what the impact on a firm’s decision to raise capital by equity, as oppose to debt.
Earnings per share or EPS is an important financial measure which is calculated by dividing the company’s net income with its total number of outstanding shares. It indicates the profitability of a company and divides net earnings available to the shareholders. EPS is calculates as- (Net income - preferred dividends) ÷ weighted average of common shares outstanding during the period.
When companies issue additional shares for financing, Share dilution happens. Share dilution means that shareholders' ownership in the company is reduced, or diluted when new shares are issued. It happens because additional shares reduce the value of the existing shares for investors.
For e.g.- If the company initially had 20,000,000 shares outstanding and a profit of $5,000,000, the company would have an EPS of .25 or 25 cents per share.
Let say the company issues another 5,000,000 shares, the total outstanding share count will now be 25,000,000. The company's revenue and earnings (profit) have not changed in value, , the company would have an EPS of .20 or 20 cents per share.
Here, we can see that due to the issuance of additional shares, the company’s EPS has declined from 0.25 to 0.20
As a result of decline in EPS, companies often find their stock price decline initially because negative or lower earnings per share do not attract investors and give poor indication about the future of the company.
Reason why companies choose to bring the capital through equity financing and not debt financing are as follows-
· There is less risk with equity financing because there is no fixed monthly loan payments. Unlike debt, there is no financial burden on the borrower.
· The interest rate involved in financing through debt is often very high and if the borrower has certain credit problems, equity financing can be a better option.
· Making debt loan payments reduces the firm’s cash flow thereby reducing the money for future growth while in equity financing, this doesn’t happen.
· Equity financing doesn’t impose restrictions on the use of capital imposed by banks or other lenders like in case of debt financing.