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Unformatted text preview: tions commonly measure profits in terms of earnings per share
(EPS), which represent the amount earned during the period on behalf of each
outstanding share of common stock. EPS are calculated by dividing the period’s
total earnings available for the firm’s common stockholders by the number of
shares of common stock outstanding. 14 PART 1 Introduction to Managerial Finance EXAMPLE Nick Dukakis, the financial manager of Neptune Manufacturing, a producer of
marine engine components, is choosing between two investments, Rotor and
Valve. The following table shows the EPS that each investment is expected to
have over its 3-year life.
Earnings per share (EPS)
Investment Year 1 Year 2 Year 3 Total for years 1, 2, and 3 Rotor $1.40 $1.00 $0.40 $2.80 Valve 0.60 1.00 1.40 3.00 In terms of the profit maximization goal, Valve would be preferred over
Rotor, because it results in higher total earnings per share over the 3-year period
($3.00 EPS compared with $2.80 EPS).
But is profit maximization a reasonable goal? No. It fails for a number of
reasons: It ignores (1) the timing of returns, (2) cash flows available to stockholders, and (3) risk.2 Timing
Because the firm can earn a return on funds it receives, the receipt of funds sooner
rather than later is preferred. In our example, in spite of the fact that the total
earnings from Rotor are smaller than those from Valve, Rotor provides much
greater earnings per share in the first year. The larger returns in year 1 could be
reinvested to provide greater future earnings. Cash Flows
Profits do not necessarily result in cash flows available to the stockholders. Owners receive cash flow in the form of either cash dividends paid them or the proceeds from selling their shares for a higher price than initially paid. Greater EPS
do not necessarily mean that a firm’s board of directors will vote to increase dividend payments.
Furthermore, higher EPS do not necessarily translate into a higher stock
price. Firms sometimes experience earnings increases without any corr...
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This document was uploaded on 01/19/2014.
- Fall '13