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:
3. Suppose that income from operations varies from year to year but is expected to be above $300,000, 40% of the time and below S300.000, 60% of the time. Should Gearing finance with notes or stock? Explain your answer.
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:
To indicate:
The decision of financing with Note or Stock.
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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