Three different plans for financing an $18,000,000 corporation are under consideration by its organizers

Three different plans for financing an $18,000,000 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
8% Bonds — — $ 9,000,000
Preferred 4% stock, $20 par — $ 9,000,000 4,500,000
Common stock, $10 par $18,000,000 9,000,000 4,500,000
Total $18,000,000 $18,000,000 $18,000,000



Instructions
1. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is $2,100,000.
2. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is $1,050,000.
3. Discuss the advantages and disadvantages of each plan.


Answer:

1. Plan 1 Plan 2 Plan 3
Earnings before interest and income tax…… $2,100,000 $2,100,000 $2,100,000
Deduct interest on bonds……………………… 0 0 720,000
Income before income tax…………………… $2,100,000 $2,100,000 $1,380,000
Deduct income tax……………………………… 840,000 840,000 552,000
Net income……………………………………… $1,260,000 $1,260,000 $ 828,000
Dividends on preferred stock………………… 0 360,000 180,000
Available for dividends on common stock…
Shares of common stock outstanding………
$1,260,000
÷1,800,000
$ 900,000
÷ 900,000
$ 648,000
÷ 450,000
Earnings per share on common stock……… $ 0.70 $ 1.00 $ 1.44
2. Plan 1 Plan 2 Plan 3
Earnings before interest and income tax…… $1,050,000 $1,050,000 $1,050,000
Deduct interest on bonds……………………… 0 0 720,000
Income before income tax……………………… $1,050,000 $1,050,000 $ 330,000
Deduct income tax……………………………… 420,000 420,000 132,000
Net income………………………………………… $ 630,000 $ 630,000 $ 198,000
Dividends on preferred stock………………… 0 360,000 180,000
Available for dividends on common stock…
Shares of common stock outstanding………
$ 630,000
÷1,800,000
$ 270,000
÷ 900,000
$ 18,000
÷ 450,000
Earnings per share on common stock……… $ 0.35 $ 0.30 $ 0.04
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. It is also more attractive to
common shareholders than is Plan 2 or 3 if earnings before interest and income tax
is $1,050,000. In this case, it has the largest EPS ($0.35). The principal disadvantage of
Plan 1 is that, if earnings before interest and income tax is $2,100,000, it offers the
lowest EPS ($0.70) on common stock.
The principal advantage of Plan 3 is that less investment would need to be made by
common shareholders. Also, it offers the largest EPS ($1.44) if earnings before interest
and income tax is $2,100,000. Its principal disadvantage is that the bonds carry a fixed
annual interest charge and require the payment of principal. It also requires a dividend
payment to preferred stockholders before a common dividend can be paid. Finally,
Plan 3 provides the lowest EPS ($0.04) if earnings before interest and income tax is
$1,050,000.
Plan 2 provides a middle ground in terms of the advantages and disadvantages
described in the preceding paragraphs for Plans 1 and 3.