Question

Quantitative Reasoning Problem 3

ACC 122

Assignment is to be completed as a Word Document, PDF, or on notebook paper and submitted through Moodle

Compare two alternatives for financing - Issuance of common stock vs. Issuance of bonds.

Northeast Airlines is considering two alternatives for the financing of the purchase of a fleet of airplanes. These two alternatives are:

1. Issue 60000 shares of common stock at $45 per share. (Cash dividends have not been paid nor is the payment of any contemplated).

2. Issue 10%, 10-year bonds at face value for $2,700,000.

It is estimated that the company will earn $800,000 before interest and taxes as a result of this purchase. The company has an estimated tax rate of 30% and has 90000 shares of common stock outstanding prior to the new financing.

Instructions:

1. How much capital is Northeast Airlines considering raising?
2. Determine the effect on net income and earnings per share for both of these methods of financing.
3. Which alternative would you recommend?
4. Why?

Show calculations as well as explain in words your thinking behind your calculations and conclusions.

Answer 1

1. Northeast Airlines is considering to raise $2700000

2. Effect on Net Income and EPS ( Amount in $)

Particulars	Alternative 1 Issuing Common stock ( 60000 shares @ $45 each)	Alternative 2 Issuing 10% bonds of $2700000
Estimated Earnings before Interest and Tax	800000	800000
Less: Interest	-	(270000) 2700000 * 10%
Earnings Before Tax	800000	530000
Less : Tax @ 30%	(240000)	(159000)
Earnings after tax (A)	560000	371000
No. of share outstanding (B)	150000 (90000 + 60000)	90000
Earnings Per Share (A/B)	3.733	4.122

Since the Earning per share is higher under alternative 2 , the same method of financing shall be recommended.

The investors are always concerned with higher EPS and therefore Alternative 2 is recommended.