The Howe Computer Company has grown rapidly during the
past 5 years. Recently, its commercial bank urged the company to consider increasing its
permanent financing. Its bank loan under a line of credit has risen to $150,000, carrying a
10% interest rate, and Howe has been 30 to 60 days late in paying trade creditors.
Discussions with an investment banker have resulted in the decision to raise $250,000
at this time. Investment bankers have assured Howe that the following alternatives are
feasible (flotation costs will be ignored):
Alternative 1: Sell common stock at $10 per share.
Alternative 2: Sell convertible bonds at a 10% coupon, convertible into 80 shares of
common stock for each $1,000 bond (i.e., the conversion price is $12.50 per share).
Alternative 3: Sell debentures with a 10% coupon; each $1,000 bond will have 80 warrants
to buy 1 share of common stock at $12.50.
Keith Howe, the president, owns 80% of Howe’s common stock and wants to maintain control
of the company; 50,000 shares are outstanding. The following are summaries of Howe’s
latest financial statements:
a. Show the new balance sheet under each alternative. For alternatives 2 and 3, show the
balance sheet after conversion of the debentures or exercise of the warrants. Assume
that $150,000 of the funds raised will be used to pay off the bank loan and the rest
used to increase total assets.
b. Show Keith Howe’s control position under each alternative, assuming that he does not
purchase additional shares.
c. What is the effect on earnings per share of each alternative if it is assumed that earnings
before interest and taxes will be 20% of total assets?
d. What will be the debt ratio under each alternative?
e. Which of the three alternatives would you recommend to Keith Howe? Why?
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Balance Sheet Current liabilities $200,000 Common stock, $1 par 50,000 Retained earnings 25,000 Total assets $275,000 Total liabilities and equity $275,000 Income Statement Sales $550,000 All costs except interest 495,000 EBIT $ 55,000 Interest 15,000 EBT $ 40,000 Taxes (40%) 16,000 Net income $ 24,000 Shares outstanding 50,000 Earnings per share $0.48 Price/earnings ratio 18 Market price of stock $8.64