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You hold a 25% common stock interest in YouOwnIt, a family-owned construction equipment company. Your sister, who is the manager, has proposed an expansion of plant facilities at an expected cost of $26,000,000. Two alternative plans have been suggested as methods of financing the expansion. Each plan is briefly described as follows: Plan 1. Issue $26,000,000 of 20-year, 8% notes at face amount Plan 2. Issue an additional 550,000 shares of $10 par common stock at $20 per share, and $15,000,000 of 20-year, 8% notes at face amount The balance sheet as of the end of the previous fiscal year is as follows: Net income has remained relatively constant over the past several years. The expansion program is expected to increase yearly income before bond interest and income tax from $2,667,000 in the previous year to $5,000,000 for this year. Your sister has asked you, as the company treasurer, to prepare an analysis of each financing plan. 1. Prepare a table indicating the expected earnings per share on the common stock under each plan. Assume an income tax rate of 40%. Round to the nearest cent. 2. a. Discuss the factors that should be considered in evaluating the two plans. b. Which plan offers greater benefit to the present stockholders? Give reasons for your opinion.
Financial Accounting
Solutions
Financial Accounting
You hold a 25% common stock interest in YouOwnIt, a family-owned construction equipment company. Your sister, who is the manager, has proposed an expansion of plant facilities at an expected cost of $26,000,000. Two alternative plans have been suggested as methods of financing the expansion. Each plan is briefly described as follows:
Plan 1. Issue $26,000,000 of 20-year, 8% notes at face amount
Plan 2. Issue an additional 550,000 shares of $10 par common stock at $20 per share, and $15,000,000 of 20-year, 8% notes at face amount
The balance sheet as of the end of the previous fiscal year is as follows:
Net income has remained relatively constant over the past several years. The expansion program is expected to increase yearly income before bond interest and income tax from $2,667,000 in the previous year to $5,000,000 for this year. Your sister has asked you, as the company treasurer, to prepare an analysis of each financing plan.
- 1. Prepare a table indicating the expected earnings per share on the common stock under each plan. Assume an income tax rate of 40%. Round to the nearest cent.
- 2.
- a.
Discuss the factors that should be considered in evaluating the two plans. - b.
Which plan offers greater benefit to the present stockholders? Give reasons for your opinion.
- a.
1.
Prepare a table indicating the expected earnings per share on the common stock under each plan.
Explanation of Solution
Earnings per share (EPS): It refers to the share of earnings earned by the shareholder on each owned. The formula to calculate the earnings per share is as follows:
Prepare a table indicating the expected earnings per share on the common stock under each plan.
| Particulars | Plan 1 | Plan 2 |
| Shares of Common Stock | 400,000 | 950,000 |
| Earnings before bond interest and income tax | $5,000,000 | $5,000,000 |
| Less: Interest on Bonds | ($2,080,000) | ($1,200,000) |
| Income before income tax | $2,920,000 | $3,800,000 |
| Less: Income Tax (40%) | ($1,168,000) | ($1,520,000) |
| Net income | $1,752,000 | $2,280,000 |
| Earnings per share | $4.38 (1) | $2 |
2(a)
Discuss the factors that should be considered in evaluating the two plans.
(b)
Explain the plan that offers greater benefit to the present stockholders.
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