Textbook Problem

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.