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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:

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.

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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