   Chapter 14, Problem 14.1APR

Chapter
Section
Textbook Problem

Effect of financing on earnings per shareThree different plans for financing an $18,000,000 corporation are under consideration by its organizers. Under each of the following plans, the securities will be issued at their par or face amount, and the income tax rate is estimated at 40% of income: Plan 1 Plan 2 Plan 3 8% Bonds — —$ 9,000,000 Preferred 4% stock. $20 par —$ 9,000,000 4,500.000 Common stock, $10 par$ 18.000,000 9,000,000 4,500,000 Total $18,000,000$18,000,000 $18,000,000 Instructions1. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is$2,100,000.2. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is $1,050,000.3. Discuss the advantages and disadvantages of each plan. 1. To determine Bonds: Bonds are long-term promissory notes that are represented by a company while borrowing money from investors to raise fund for financing the operations. Common stock: It refers to a security issued in a form of certificate and implies the right of ownership of an investor over a portion of company’s earnings and assets. Earnings per Share: It is a portion of profit that is earned by each common stock. Formula: Earnings per share(EPS)=Net income Preferred dividends Number of common shares outstanding To Determine: Earnings per share of common stock for each plan, if income before bond interest and income tax is$2,100,000.

Explanation

Determine Earnings per share of common stock.

 Particulars Plan 1 Plan 2 Plan 3 Net income before interest on bonds and income tax $2,100,000$2,100,000 $2,100,000 Less: Interest on bonds - -$720,000(1) Income before income tax $2,100,000$2,100,000 $1,380,000 Less: Income tax expense$840,000(2) $840,000(2)$552,000(3) Net income $1,260,000$1,260,000 $828,000 Dividends on preferred stock -$360,000(4) $180,000(5) Available for dividends on common stock$1,260,000 $900,000$648,000 Number of common stock outstanding ÷ 1,800,000(6) ÷ 900,000(7) ÷ 450,000(8) Earnings per share of common stock $0.70$1.00 $1.44 Table (1) Working notes: Calculate interest on bonds for plan 3. Interest expense=Facevalueofbonds×Rate of Interest=$9,000,000×8%=$720,000 (1) Calculate income tax expense for plan 1 and plan 2. Income tax expense=(Incomebeforeincometax×Incometaxpercentage)=$2,100,000×40%=$840,000 (2) Calculate income tax expense for plan 3 2. To determine Earnings per share of common stock for each plan, if income before bond interest and income tax is$1,050,000.

3.

To determine

To describe: The advantages and disadvantages of each plans.

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