Losing Shareholder Value in Share Dilution

EPS = NI / # common shares; EPS diluted < EPS basic; share dilution (loss in existing shareholders' value).

Let's use an example to show how EPS dilution occurs. A fictitious company called General Ford wants to build a new facility to meet future demand of--vacuums. There is 1 million common shares and no debt currently (haha, you CAN tell it's fiction). The current market share price = $5 --> market value =$5MM. Book value = $10MM --> $10 per share.

General Ford has experienced difficulties, including cost overruns, regulatory delays, and below normal profits. Market-to-Book ratio = 5/10 = 0.5. (Successful firms rarely have market prices less than book values.)

More info:

Net Income = $1MMI= --> EPS = $1 --> ROE = 1/10 = 10%

Price/earnings ratio (P/E ratio) = 5 (General Ford sells for five times earnings);
They have 200 shareholders, each of whom hold 5000 shares each; the cost of new plant = $2MM

Q. How many new shares should be issued?

General Ford has to issue 400,000 new shares ($2mm/$5) --> 1.4 MM shares after the issue

If ROE is fixed, NI is expected to go up by: 0.10 * 2MM = $200,000 --> Total NI = $1.2MM

What's going to happen?

- EPS = 1.2/1.4 = $ 0.857 per share, down from $1 (1.2/1.2)
- The % of ownership of each old shareholder drops to 0.36% (=5,000/1.4MM) from 0.5%
-If P/E ratio is still 5, the market price will be $4.29 per share (=5*0.857), a loss of $0.71 per share
- Total book value = $12MM (=10+2) --> book value per share falls to $8.57 per share ($ 12MM/1.4MM)

There completes this fictitious example of General Ford and if they raise cash through the stock market by devaluing their common shares.

Dilution and Earnings Per Share: Financial Terms and Explanations is a post from: Discuss Economics Blog

Here is a brief synopsis of key financial terms for introductory finance majors and business folks regarding income statements and balance sheets. Firstly, defining some terms:

Income Statement : A statement measuring a firm's financial performance over a period of time. Generally, it records revenues and expenses to derive income over a specified period

Balance Sheet : This analysis sheet provides a "snapshot" at a point of time of the firm's health in terms of total assets (what do they own), total liabilities (what do they owe), and equity (how much of the firm's assets are financed by the owners).

The basic idea for financial statements is to make decisions and provide information on the firm. At the most essential element you seek: Revenue - Expenses = Income

The time period can vary, perhaps monthly, quarterly, or annually.

Financial Statement Formulas:

Sales (Revenue) - Cost of Goods Sold (COGS) - operating costs and depreciation = Earnings Before Interest and Tax (EBIT)

- interest paid = Earnings Before Tax (EBT) or taxable income - Taxes = NET INCOME (NI)

Highlights: The initial thing reported on an income statement is revenue & expenses from the firm's principal operations. Revenue - operating expenses = EBITI

Subsequent parts include the financial expenses (interest paid), Taxable income (EBT), Taxes paid. Combine them all and you are left with the last item: Net income.

About Revenue: Also called sales or net sales, revenue is what a business earns for the sale of its products and/or services. Therefore in a basic formula:

Net Sales = Gross sales - Returned products - Discounts taken for prompt payments of invoices - Allowances made for damaged products

About the Expenses: Let's talk briefly about expenses including the Cost of Goods Sold (COGS). COGS is the cost incurred in making or producing the goods that were sold (also called Cost of Sales). The value captures manufacturing expenses for the products sold. So that would mean: raw material + labor + factory overhead (which includes utility, property taxes, insurance, etc.)

Also included in expenses is operating costs, also called G&A (General & Administrative) expenses. Selling expenses, marketing expenses and Administration which includes: Selling: salespeople's salaries, bonuses, office expenses, etc; Marketing: promotions, advertising, marketing research, salaries, etc.; Administrative: corporate & divisional staff, executive compensation, R&D, etc.

Don't forget depreciation is not treated the same. Equipment and building and land = NO depreciation, (and when you depreciate never goes to zero; depreciation also becomes part of cash flow.)

Switching gears let's talk more specifically about Net Income (NI), in this case on a per-share basis. The formula would be: Earnings per share (EPS) = NI / # of common shares. This changes when you consider distribution of Net Income, then the formula is: Net Income = Dividend paid to shareholders + Addition to Retained Earnings. When you consider the stock market: market price / earnings per share = P/E ratio.

This discussion continues with a discussion on earnings per share and dilution.

Financial Statements – Terms and Explanations is a post from: Discuss Economics Blog

We have written a few key articles on the area of cash flow analysis here at DiscussEconomics. This article will give you a quick summary of each article and correlating link for easy review of each topic. Feel free to book mark and link to this page.

• Cash Flow Analysis Introduction: Intro to cash flow analysis as one of the most important pieces of financial information for a firm.
• Net Present Value (NPV) of Cash Flow Analysis: The topic of net present value of cash flow (or NPV), measuring and comparing benefits and costs, including formulas.
• Using NPV and Interest Rates for Discount Purposes: The NPV of any project is sensitive to the interest rate used for discounting cash flows (costs, which usually occur at time 0, are not discounted, while cash inflows closer to the end of the project are heavily discounted). Formulas included.
• IRR is an indicator of the efficiency or quality of an investment, as opposed to net present value (NPV), which indicates value or magnitude. Read about the IRR rule.
• Sensitivity Analysis in Project Evaluation: Many times the variables that underlie cash flows or the interest rate for discount purposes are not known with certainty, so firms estimate them and use the best guessed values to perform the necessary project analysis....
• Top Five Cash Flow Analysis Methods: The first step in this analysis is to calculate the cash flows and discounted cash flows (with the previous years' cash flows (up to and including the current year) and will show how much money is still invested or tied in the project at this time. appropriate signs) generated by the project. Based on them we can calculate the following....

Free List of Cash Flow Analysis Articles is a post from: Discuss Economics Blog

The main methods used for project evaluation are the NPV method and the IRR method. According to them, an investment project is viable if the NPV is positive or if the IRR is higher than the cost of capital. In most cases these two methods will yield the same conclusion regarding the profitability of a project, and when not, the NPV method is more accurate.

Both the NPV and the IRR of a project depend on the cash flows associated with the project, which in tum depend on many factors: the initial investment(s) required by the project, the revenues to be expected and their evolution in time, the discount interest rate, which in tum depends on the required return on the project, the inflation component and the uncertainty component, etc.

Many times the variables that underlie the project's cash flows or the interest rate for discount purposes are not known with certainty, so firms estimate them and use the best guessed values to perform the necessary project analysis. Any change in one of these variables compared to the estimated value can affect the NPV of the project or whether the IRR is greater than the cost of capital.

It is therefore necessary to assess the degree of the forecasting risk for these variables and to what extent they might affect the profitability of the project, as well as to identify the variables that are most critical to the success or failure of the project.

Sensitivity analysis investigates what happens to the NPV and IRR of the project when one or more variables change. The idea is that we freeze all the variables except the one(s) analyzed and check how sensitive the NPV and/or the IRR are to changes in that variable. We don't have specific examples to show you (you can do many scenarios in Excel). However, look back into our cash flow series and familiarize yourself with tools of the cash flow trade.

This post is part of a series of articles on cash flow analysis. Visit our cash flow analysis page to find a summary of each method.

Project Evaluation – Sensitivity Analysis (Cash Flow) is a post from: Discuss Economics Blog

This post continues a discussion about cash flow, net present value, interest rates and NPV, and IRR, which you can read by clicking on the specific links. This post deals with the topic of using these tools for conduction cash flow analysis.

The methods of evaluating the opportunity of an investment project are the NPV method and the IRR method. If the NPV of the project is greater than zero or the IRR is greater than some minimum predetermined rate, the project is profitable, thus it should be undertaken.

However, a strong piece of information to consider is the firms cash flows over time. This way we will have a more detailed image of the project and see not only if the project is profitable, but also when it becomes profitable, how much of the initial cost is recovered every year, etc.

The first step in this analysis is to calculate the cash flows and discounted cash flows (with the previous years' cash flows (up to and including the current year) and will show how much money is still invested or tied in the project at this time. appropriate signs) generated by the project. Based on them we can calculate the following:

1) The percentage of the discounted cash flows in the initial investment.

Usually the investment or the initial cost occurs in the first year(s) of the project and is registered as a negative cash flow. If the investment is spread over several years, the initial investment is considered to be the sum of all these yearly expenditures, or more correctly the sum of all discounted expenditures (which is the PV in the first year of all investments to be made for the project).

The percentage of each cash flow in the initial investment tells us how much we invest or how much we recover from our total investment every year during the economic life of the project.

If the initial investment is considered in absolute value, thus a positive number, and each cash flow is considered with the appropriate sign, then the percentage of discounted cash flows will be negative for the years when the project requires investments and positive for the years when the project generates revenues.

2) The accumulated percentage of the discounted cash flows in the initial investment.

For each year, it is simply the sum of the percentages previously calculated for all the years before and including the year considered. It roughly shows how deep we are into debt. An accumulated percentage of -100% will be obtained for the year when the investment is completed. This is when the debt is the 'deepest'. After this year we will start recovering some part of the investment every year and the accumulated percentage will show how much there is still to be recovered from the investment. The accumulated percentage for the last year will equal the percentage of the PV ofthe project (i.e. the sum of all discounted cash flows) in the initial expenditures or investment.

3) Cash balances

They are the sum of all cash flows already realized at any given point of time (considered with the appropriate signs). For each year the cash balance will equal the sum of all Cash balances are initially negative for most projects, as they start with expenditures (investments). It is important to note the maximum (negative) cash balance in absolute value and when it occurs. This number will show the maximum investment that, at some point in time, is tied in the project. Even if the project is overall profitable (check this through the NPV and IRR methods), if one cannot procure this maximum (negative) cash balance at the particular time when it occurs, one cannot undertake the project.

As the project starts generating revenues, cash flows become positive, thus the negative cash balances decrease in magnitude, but are still negative for a while (as long as revenues generated by the project do not exceed the investment). The decrease in the absolute value of cash balances simply shows that the investor starts to recover part of the investment made.

A second thing important to note is when we obtain the first positive cash balance. This moment is called payback period and represents the period of time needed to recover all the initial investment and obtain the first dollar of profit.

The sum of all cash balances at the end of the project will equal the sum of all undiscounted cash flows. A problem raised by cash balances is that they do not take into account the interest that must be paid for any amount borrowed from the bank or the interest earned on any amount saved in the bank. In reality, the negative cash balances carried forward from one year to another in the first years of the project are equivalent to a debt, on which interest should be paid. Once cash balances tum positive, they are equivalent to some money saved in the bank and interest is earned for all subsequent years.

Thus, a better measure of the amount of money tied in the project is given by the interest based cash balances.

4) The interest based cash balance (IBCB)

The IBCB for the current period is obtained by adding the current (undiscounted) cash flow to the IBCB carried from the previous period and the interest that applies to it (the formula doesn't work with subscripts). Like cash balances, IBCBs for the project are negative for the first years (due to investments or outflows) and become positive as the project generates enough revenues to recover the costs. For most of the projects the maximum negative IBCB, which shows the maximum amount invested in a project at any given point in time (when interest is considered) is greater than the maximum negative cash balance. This is simply because for any amount invested, like for any debt, interest should be paid.

The interest based payback period (or discounted payback period) is the moment when the project's inflows exceed the project outflows, interest being considered, or the moment when we obtain the first positive IBCB. It is usually larger than the payback period. The reason for this is that we need time to recover not only the initial investments or expenditures, but also the interest that applies to them. The last IBCB obtained for the project will equal the future value of the project in the final year (the accumulated sum of all cash flows compounded with the appropriate interest rate).

5) The profitability index- PI (the cost-benefit ratio)

This ratio calculates the PV of all inflows (benefits) to the PV of all outflows (costs). A project is profitable when its NPV is positive, thus the PV of benefits is higher than the PV of costs. It must be then that the project should be undertaken when the profitability index is greater than 1, and it is not profitable when the index is less than 1.

This post is part of a series of articles on cash flow analysis. Visit our cash flow analysis page to find a summary of each method.

Top Five Analyses to Evaluate Cash Flow is a post from: Discuss Economics Blog

This post continues a discussion about cash flow, net present value, and interest rates and NPV, which you can read by clicking on the specific links. This post deals with the topic of internal rate of return.

IRR is an indicator of the efficiency or quality of an investment, as opposed to net present value (NPV), which indicates value or magnitude. It is the interest rate that results in a zero NPV when used as the discount rate. Or it is the discount interest rate for which the present worth of all cash inflows equals the present worth of all cash outflows. It is called internal rate of return because the money invested in this project generates (internally, within the project) exactly this rate of return. In particular for bonds, the IRR is called yield to maturity (YTM).

The IRR Rule

The IRR rule states that an investment is acceptable if the IRR exceeds the required rate of return (or the interest rate for discounting purposes) and it should be rejected otherwise. In other words, if a higher rate of return can be generated by some other projects (so the discount interest rate is higher than the IRR), then the project we currently analyze is not attractive. But if the IRR is higher then the alternative rate of return from another project, the current project is profitable.

If the project involves payments made over more than two periods, the IRR is very difficult (even impossible) to be solved for algebraically. Therefore in most cases the IRR is calculated by trial and error. Considering a particular discount interest rate one should calculate the NPV. If it is positive (negative), one should consider a higher (lower) discount interest rate and calculate the corresponding NPV. The procedure continues until the NPV approaches 0.

The problem raised by the IRR method for project evaluation is that there can be more IRRs for one project and in some situations it might be difficult to identify the appropriate one. Without entering in complicated financial details, the IRR is a good method if:

1. The project has "conventional" cash flows: the first cash flow (the initial investment) is negative and all the rest are positive.
2. We are not trying to compare mutually exclusive investment projects.

If one of the two conditions described above is not fulfilled the IRR method is not a safe method for project evaluation and the NPV method should be used instead. For example, if we try to find which project out of more mutually exclusive projects is more profitable, the correct answer is the one with the highest NPV (the largest difference between discounted revenues and discounted costs). However this is not necessarily the project with the highest IRR.

Excel calculates the IRR using a function with the same name. This function calculates the IRR iteratively starting with a guess value for the IRR, which is one of the arguments we need to specify in the function: = IRR(values, guess)

The first argument- "values" represents the range or the group of cells containing the stream of cash flows generated by the project (like the second argument in the NPV function). The IRR function is based, like the NPV function, on discounting the cash flows one period before the first cash flow occurs. We know already that the formulas for the NPV have to be slightly modified if we want need to calculate the NPV at the time of the first cash flow and not one period before that. However, the result of the IRR function is the discount rate for which the NPV one period before the first cash flow equals zero. This means that the NPV at the time of the first cash flow, which is just (1 + r) times the NPV for the previous period, will also equal O. So the result of the IRR function is not affected by the particular way Excel calculates the NPV.

This post is part of a series of articles on cash flow analysis. Visit our cash flow analysis page to find a summary of each method.

Internal Rate of Return, Cash Flow, and NPV is a post from: Discuss Economics Blog

This post continues a discussion about cash flow and net present value which you can read by clicking on the specific links. This post deals with a major factor on NPV which is the fluctuating interest rate. This variable can change outlook in a hurry.

The NPV (net present value) of any project is very sensitive to the interest rate used for discounting cash flows (costs, which usually occur at time 0, are not discounted, while cash inflows closer to the end of the project are heavily discounted). Therefore choosing the appropriate interest rate is very important.

The interest rate used for discounting should equal the opportunity cost of money / capital which is:

• the best return if this money would be invested in another project (in case the investor owns the initial capital)

• the lowest cost of financing (if the project is financed through a loan).

This is also referred to as the required rate of return.

So how can you be sure to discover the RRR? After determining the appropriate rate of return that the project should generate, there are two other elements that we should consider: inflation and risk. Thus the rate of interest for discount purposes, r, should reflect:
• the (real) required return component: rr (or the opportunity cost of money),
• the inflation component: s,
• the uncertainty component: u.

(l + r) = (l + rr) (l + i) (l + u)
So: r = (1 + rr)(l + i)(l + u) - 1


Sometimes r is calculated approximately as r = rr + i + u. This approximation works reasonably well for small values but it creates discrepancies when rr, i and u are rather large percentages, thus the multiplicative formula is the correct one.

If the appropriate interest rate is still hard to calculate, the project can be evaluated separately for different interest rates. If the NPV is positive in all cases then the profitability of the project is relatively robust to changes in the interest rate and the project should be adopted.

This post is part of a series of articles on cash flow analysis. Visit our cash flow analysis page to find a summary of each method.

[tags]inflation, risk, npv, cash flow, interest rates[/tags]

NPV and Interest Rates for Discount Purposes is a post from: Discuss Economics Blog

Moving forward now to the topic of net present value of cash flow (or NPV). An investment project generally should be undertaken if benefits outweigh costs. In order to compare the two categories we must convert them first to the same time period by finding their present value. If the PV of benefits is greater than the PV of costs the project is profitable.

Usually the costs of the project incur in year 0 while benefits incur in years 1 to t. The difference between the PV of benefits and costs is called net present value (NPV). If we denote with Ao the initial cash flow (negative if it is a cost, positive if it is revenue) and with AI, ... , At all the future cash flows, the net present value of the project is:

where d = 1/(1 + r) is the discount factor for one year and r is the interest rate for discount purposes.

In order to obtain this result we can calculate the present value of each cash flow separately (with the corresponding sign) and add them up together, you can also the Excel NPV function: = NPV (Interest rate, Range)

(For the range select or specify the range of cells containing the undiscounted cash flows. )

The NPV function operates similarly to the PV function, i.e. it calculates the PV of all cash flows for the period before the first cash flow occurs. If the first cash flow occurs in year "0", then the NPV function discounts everything to period "-1 ''. As we usually want to find the NPV at period 0 we should compound the result of the NPV function for one period, i.e. multiply it by (1 + r). Or we can calculate the NPV at year 0 by adding the first cash flow to the present value of all the subsequent cash flows, as:

Thus, the NPV rule: An investment project should be accepted if the NPV is positive and rejected if not.

This post is part of a series of articles on cash flow analysis. Visit our cash flow analysis page to find a summary of each method.

The Net Present Value of Cash Flow is a post from: Discuss Economics Blog

What is cash flow? Simply, the cash flow is the difference between the amount of dollars that enter the firm and the amount of dollars that exit the firm.

There are different types of cash flow, but for the purpose of this course it is enough if we treat all of them equally. Basically the cash flow in our examples will summarize the total cash result from all the transactions a firm is involved in during a year. The activities that bring cash are considered sources of cash and they result in cash inflows (revenues). The activities that spend cash are called uses (or applications) of cash. They will result in cash outflows (costs). The difference between cash inflows and cash outflows during a period will be the net cash flow (or sometimes simply cash flow).

There are many types of investments that companies can do:

• Financial investments: start with a cash outflow (security price) which is known; revenues are also known usually.

• Equity investments: the initial price is known but the future revenues are unknown usually, compared to financial investments (e.g.: shares vs. bonds). Thus cash flows are difficult to estimate.

• Real investments: building a plant, starting a business, etc. The future cash flows can be estimated and are used to determine whether the project is profitable or not. However these cash flows are subject to risk.

• Government investments: they involve certain costs and benefits for different groups of population. The flows of costs and benefits are compared to determine the usefulness of the projects using the so-called cost-benefit analysis.

In order to evaluate any investment project we must know the flows of costs and benefits. Generally, any project starts with some costs (cash outflows) and revenues follow later (cash inflows). Many analyses tools can be found in basic Excel packages for the student or small business.

This post is part of a series of articles on cash flow analysis. Visit our cash flow analysis page to find a summary of each method.

[tags]cash flow[/tags]

Project Evaluation – Cash Flow Analysis Intro is a post from: Discuss Economics Blog

All of the Fidelity Managed Portfolios invest in a mix of Canadian, U.S.and international equities and bonds including global real estate. There are six portfolios that meet the full range of investors' needs, risk tolerances and investment criteria.

For investors looking for income solutions

- Fidelity Income Portfolio is for the investor who needs income today,
while at the same time is looking for some long-term capital
appreciation. This investor typically has a low-to-moderate risk
tolerance
- Fidelity Global Income Portfolio offers investors with a low-to-
moderate risk tolerance a regular income stream from a geographically
diverse portfolio.

For investors looking for a balance of capital preservation and growth
potential

- Fidelity Balanced Portfolio offers investors a combination of capital
preservation and growth potential with moderate risk levels.
- Fidelity Global Balanced Portfolio is for the investor who desires a
balanced approach to investing with a global bias. This portfolio also
assumes a moderate level of risk to achieve its goals.

For investors looking for growth potential

- Fidelity Growth Portfolio offers balanced exposure to both Canadian
and global markets with strong growth potential. This portfolio is for
the investor that is typically willing to take on a moderate-to-high
level of risk to achieve their goals.
- Fidelity Global Growth Portfolio capitalizes on the rapid pace of
growth around the world. This portfolio is for the investor with a
moderate-to-high risk tolerance looking for global growth potential.

Fidelity Managed Portfolios offer investors regular rebalancing and daily monitoring of risk and return characteristics to ensure the portfolios consistently meet their investment objectives. Investors also receive access to enhanced reporting to monitor on-going investment needs and performance. All six Fidelity Managed Portfolios are offered in both capital class versions within Fidelity's Capital Structure as well as within Fidelity's Tax-efficient Systematic Withdrawal Plan (T-SWP). For investors looking for tax-efficient savings, they should consider Fidelity Capital Structure, a non-registered product offering that provides the "registered plan advantage" of maximized compound growth potential through the deferral of capital gains taxes. For investors interested in tax-efficient cash flow streams, Fidelity's T-SWP 5% or 8% options offer income solutions for non-registered assets.

The financial advisor plays an instrumental role in the investment decision process by using Fidelity's Investor Profile Questionnaire, Investment Policy Statement and enhanced reporting to customize the solution for their clients. Fidelity Managed Portfolios are a single ticket solution
with a $25,000 minimum investment required for all portfolios.

Fidelity launches six new Fidelity Managed Portfolios is a post from: Discuss Economics Blog