Earnings per share if a company decreases when additional capital it wants is ob

Question

Earnings per share if a company decreases when additional capital it wants is obtained by issuing new stocks. Please explain how this phenomenon comes about. Please also discuss how this decrease in EPS would affect a company's decision whether to issue equity (shares of stock) or debt (bond issue) for raising capital. Earnings per share if a company decreases when additional capital it wants is obtained by issuing new stocks. Please explain how this phenomenon comes about. Please also discuss how this decrease in EPS would affect a company's decision whether to issue equity (shares of stock) or debt (bond issue) for raising capital.

Explanation / Answer

Earnings per share is calculated by the formula (Net income - preferred dividends)/# common shares outstanding.

Additional capital raised through issue of common stock would increase the # shares outstanding (the denominator of the ratio). If the Net income - preferred dividends does not rise proportionate to the increase in # of shares, the EPS will come down.

The decrease in EPS due to raising of additional capital can be offset to some extent by increasing the financial leverage; ie: increasing the proportion of debt in the additional finance that is being raised. This is possible when the return from investing the additional finance is more than the cost of debt.

But when the debt content is increased beyond a point, the PE multiple may come down as the market perceives that the firm is becoming increasingly risky. Hence, a firm should use that capital structure for which the expected market price of the common stock share would be maximum. To arrive at such a capital structure, the firm should do an EBIT-EPS-Market price analysis. In such an exercise the firm should calculate the EPS with different combination of debt and equity for a particular level of EBIT. The PE ratios may also be estimated and the possible market price for each option calculated as EPS*PE ratio. The financing option that is likely to give the maximum price is to be chosen.

Related Questions

Navigate

• Browse (All)
• Browse E
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.