Question

Effect of Financing on Earnings Per Share

Three different plans for financing an $2,000,000 corporation are under consideration by its organizers. Under each of the following plans, the securities will be issued at their par or face amount, and the income tax rate is estimated at 40% of income:

		Plan 1		Plan 2		Plan 3
10% bonds		_		_		$1,000,000
Preferred 10% stock, $40 par		_		$1,000,000		500,000
Common stock, $2 par		$2,000,000		1,000,000		500,000
	Total	$ 2,000,000		$ 2,000,000		$ 2,000,000

Required:

1. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is $4,000,000. Enter answers in dollars and cents, rounding to the nearest cent.

	Earnings Per Share on Common Stock
Plan 1	$
Plan 2	$
Plan 3	$

2. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is $1,900,000. Enter answers in dollars and cents, rounding to the nearest cent.

	Earnings Per Share on Common Stock
Plan 1	$
Plan 2	$
Plan 3	$

3. The principal of Plan 1 is that it involves only the issuance of common stock, which does not require a periodic interest payment or return of principal, and a payment of preferred dividends required.

Answer 1

1.determining EPS if income before bond interest and income tax is $4,000,000.

	Plan 1	Plan 2	Plan 3
EBIT (given)	$4,000,000	$4,000,000	$4,000,000
less:interest on 10% bonds	nil	nil	(100,000)
Earnings before tax	$4,000,000	$4,000,000	$3,900,000
less: tax @40%	(1,600,000)	(1,600,000)	(1,560,000)
Earnings after tax	$2,400,000	$2,400,000	$2,340,000
less: preferred dividend @10%	nil	(100,000)	(50,000)
Net income	$2,400,000	$2,300,000	$2,290,000
number of shares (par value / $2)	1,000,000	500,000	250,000
EPS (net income / number of shares)	$2.40	$4.60	$9.16

2.if EBIT is $1,900,000.

	Plan 1	plan 2	plan 3
EBIT (given)	$1,900,000	$1,900,000	$1,900,000
less: interest on 10% bonds	nil	nil	(100,000)
EBT	$1,900,000	$1,900,000	$1,800,000
less: tax @40%	(760,000)	(760,000)	(720,000)
EAT	$1,140,000	$1,140,000	$1,080,000
less: preferred dividend	nil	(100,000)	(50,000)
net income	$1,140,000	$1,040,000	$1,030,000
number of shares	1,000,000	500,000	250,000
EPS	$1.14	$2.08	$4.12

3.The principal ADVANTAGE of plan 1 is that it involves only the issuance of common stock , which does not require a periodic interest payment or return of principal and a payment of preferred dividends is NOT required.