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Cornerstones of Financial Accounti...

4th Edition
Jay Rich + 1 other
ISBN: 9781337690881

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Cornerstones of Financial Accounti...

4th Edition
Jay Rich + 1 other
ISBN: 9781337690881
Textbook Problem
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Evaluating Leverage

Gearing Manufacturing Inc. is planning a $1,000,000 expansion of its production facilities. The expansion could be financed by the sale of $1,250,000 in 8% notes or by the sale of $1,250,000 in common stock, which would raise the number of shares outstanding from 50,000 to 75,000. Gearing pays income taxes at a rate of 30%.

Required:

2. Suppose that income from operations is expected to be S275.000 per year for the duration of the proposed debt issue. Should Gearing finance with notes or stock? Explain your answer.

To determine

Concept introduction:

Basic Earnings per share:

The Basic Earnings per share is the amount of net income earned by each common share outstanding. The Earnings per share calculated by with help of following formula:

Basic Earnings per share=Net Income - Preferred DividendWeighted Average Common Shares Outstanding

 Net Income available to common stockholder = Net income  Preferred Dividend

To indicate:

The decision of financing with Note or Stock.

Explanation

The decision for financing is taken on the basis of the following analysis:

Gearing Manufacturing Inc.
If Financed with Notes If Financed with Stock
Income from Operation (A) $ 275,000 $ 275,000
Less: Interest Expense (B) (1250000*8%) $ 100,000 $ -
Income before tax (C) = (A-B) $ 175,000

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