Dr. P.V. Viswanath

pviswanath@pace.edu

Common Misconceptions in Finance

© P.V. Viswanath, 1999, 2000, 2005

• Issuing equity dilutes earnings
• Payment of dividends is always bad for bondholders
• Payment of dividends is always good for stockholders
• If earnings are predictable, then it should be possible to predict stock prices, as well.
• If increasing the proportion of debt in a company's capital structure increases the riskiness of the firm's bonds and it increases the riskiness of the firm's stock, then it must increase the riskiness of the entire firm.
• The Fed sets interest rates

Issuing equity dilutes earnings: This would be true if earnings did not increase, but the number of shares outstanding did. However, the issuance of equity would allow the company to buy assets, which would generate more earnings. Hence, it is not obvious that issuing equity per se would dilute earnings.

Consider the following related question.  On November 2000, it was announced that Pepsi had made an offer for Quaker Oats.  The deal that Pepsi offered was two Pepsi shares, for each share of Quaker. At the close of the previous day, Pepsi had been trading at $48, while Quaker was selling for $82.25. At the end of November, 2, Pepsi was off 94 cents, while Quaker was unchanged.  The news reports at that time, even though they considered the acquisition desirable in terms of strategic fit had the following negative things to say:

Depending on the price and the potential for cost savings, the deal could hurt Pepsi's earnings, potentially upsetting Pepsi investors who have escaped the carnage of other consumer-products companies who have stumbled as a result of weak earnings or bad acquisitions. (Dow Jones Newswires -- November 2, 2000)

As of late last week, the stumbling block was price. Although Mr. Morrison (CEO, Quaker) sought a higher premium, Mr. Enrico (CEO of Pepsico) hesitated because he was concerned that the deal not only would dilute PepsiCo's earnings, but also drive the stock price down from $47 into the low-$40 range, news reports said. (Crain's Chicago Business, November 6, 2000).

Since the argument is that Pepsi would be negatively affected by the use of equity to acquire Quaker, i.e., the reason provided is not that Pepsi is overpaying for Quaker, let us make the neutral assumption that Pepsi is paying $12.956 billion for Quaker, i.e. the market value of Quaker's assets (estimated as in the table above).  Then, using a share price of $48 (Nov. 1 closing) for Pepsi, it will have to issue 12.956/48 = 0.27 billion new shares.  Now, let us look at the impact of the acquisition on Pepsi's earnings per share under two different assumptions: one, that they use debt to pay for Quaker, and two, that they use equity to pay for Quaker.

If Pepsi uses debt to pay for Quaker, there will be no increase in the number of shares outstanding.  Total earnings will increase from $2.016 to 2.016 + 0.35 = $2.366b.  Hence earnings per share will be $1.64.  If Pepsi uses equity, the number of shares outstanding is 1.44 + 0.27 = 1.71 billion, as computed above.  The earnings per share, then, will be 2.366/1.71 = $1.3837.  It is clear, therefore, that earnings per share will be negatively affected by the use of equity for the acquisition.

However, if Pepsi paid market value for Quaker Oats, i.e., fair value, the acquisition is, essentially, a zero net present value project.  Hence, almost by definition, there should be no impact on Pepsi's price.  In other words, the dilution of Pepsi's earnings is a red herring, as long as it pays no more than a fair price for Quaker.

Payment of dividends is always bad for bondholders: Paying dividends keeps stockholders happy, which raises the value of the entire firm; it does not hurt bondholder interests, when it is expected and built into the price paid by bondholders. Furthermore, keeping overly high levels of free cash on hand could mean bad operating decisions by managers, which could affect the health of the entire firm.

Payment of dividends is always good for stockholders: Payment of excessive dividends could mean that the firm is without sufficient ready cash to meet current operating needs and/or investment in positive NPV projects.  It may, therefore, have to resort to costly external financing, which might reduce the net present value of the investment project to zero, or, at the very least, would put a dent in earnings.

The Fed sets Interest Rates: The Fed sets targets for the Fed Funds rate. The Fed Funds rate, which represents the rate at which Fed Reserve banks lend to each other is obviously influenced by the Fed's target rate. If the Fed Funds rate rose much higher than the Fed's target, the Fed could inject more funds into the system. This would presumably reduce (nominal) interest rates in the short run. However, even if the Fed does control access to dollars (money), it does not have access to unlimited real resources. Consequently, the Fed ultimately has much more limited ability to affect real interest rates, except to the extent that it can affect demand for and supply of real resources. And to the extent that it cannot affect real interest rates in the long run, it cannot affect nominal rates in the long run, either, since the nominal rate is simply the real rate plus the rate of inflation. Read the following article for one point of view. (There's Nothing to Fear From a Rate Hike by James Surowiecki, posted June 15, 1999 at Moneybox at Slate.)