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 38% Bonds — — $ 9,000,000Preferred 4% stock, $20 par — $ 9,000,000 4,500,000Common stock, $10 par $18,000,000 9,000,000 4,500,000Total $18,000,000 $18,000,000 $18,000,000Instructions1. 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 3Earnings before interest and income tax…… $2,100,000 $2,100,000 $2,100,000Deduct interest on bonds……………………… 0 0 720,000Income before income tax…………………… $2,100,000 $2,100,000 $1,380,000Deduct income tax……………………………… 840,000 840,000 552,000Net income……………………………………… $1,260,000 $1,260,000 $ 828,000Dividends on preferred stock………………… 0 360,000 180,000Available for dividends on common stock…Shares of common stock outstanding………$1,260,000÷1,800,000$ 900,000÷ 900,000$ 648,000÷ 450,000Earnings per share on common stock……… $ 0.70 $ 1.00 $ 1.442. Plan 1 Plan 2 Plan 3Earnings before interest and income tax…… $1,050,000 $1,050,000 $1,050,000Deduct interest on bonds……………………… 0 0 720,000Income before income tax……………………… $1,050,000 $1,050,000 $ 330,000Deduct income tax……………………………… 420,000 420,000 132,000Net income………………………………………… $ 630,000 $ 630,000 $ 198,000Dividends on preferred stock………………… 0 360,000 180,000Available for dividends on common stock…Shares of common stock outstanding………$ 630,000÷1,800,000$ 270,000÷ 900,000$ 18,000÷ 450,000Earnings per share on common stock……… $ 0.35 $ 0.30 $ 0.043. The principal advantage of Plan 1 is that it involves only the issuance of commonstock, 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 tocommon shareholders than is Plan 2 or 3 if earnings before interest and income taxis $1,050,000. In this case, it has the largest EPS ($0.35). The principal disadvantage ofPlan 1 is that, if earnings before interest and income tax is $2,100,000, it offers thelowest EPS ($0.70) on common stock.The principal advantage of Plan 3 is that less investment would need to be made bycommon shareholders. Also, it offers the largest EPS ($1.44) if earnings before interestand income tax is $2,100,000. Its principal disadvantage is that the bonds carry a fixedannual interest charge and require the payment of principal. It also requires a dividendpayment 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 disadvantagesdescribed in the preceding paragraphs for Plans 1 and 3.
Wishaw, Inc. produces and sells outdoor equipment. On July 1, 2014, Wishaw, Inc. issued $150,000,000 of 20-year, 12% bonds at a market (effective) interest rate of 9%, receiving cash of $191,403,720. Interest on the bonds is payable semiannually on December 31 and June 30. The fiscal year of the company is the calendar year.Instructions1. Journalize the entry to record the amount of cash proceeds from the issuance of the bonds on July 1, 2014.2. Journalize the entries to record the following:a. The first semiannual interest payment on December 31, 2014, and the amortization of the bond premium, using the straight-line method. (Round to the nearest dollar.)b. The interest payment on June 30, 2015, and the amortization of the bond premium, using the straight-line method. (Round to the nearest dollar.)3. Determine the total interest expense for 2014.4. Will the bond proceeds always be greater than the face amount of the bonds when the contract rate is greater than the market rate of interest?5. (Appendix 1) Compute the price of 191,403,720 received for the bonds by using the present value tables in Appendix A at the end of the text. (Round to the nearest dollar.)Answer:
1. Cash 191,403,720Premium on Bonds Payable 41,403,720Bonds Payable 150,000,0002. a. Interest Expense 7,964,907Premium on Bonds Payable* 1,035,093Cash 9,000,000* $41,403,720 ÷ 40 seminannual paymentsb. Interest Expense 7,964,907Premium on Bonds Payable* 1,035,093Cash 9,000,000* $41,403,720 ÷ 40 semiannual payments3. $7,964,9074. Yes. Investors will be willing to pay more than the face amount of the bondswhen the interest payments they will receive from the bonds exceed the amountof interest that they could receive from investing in other bonds.5. Present value of $1 for 40 semiannualperiods at 4.5% semiannual rate……………………………… 0.17193Face amount of bonds…………………………………………… ×Present value of annuity of $1$150,000,000 $ 25,789,500for 40 semiannual periods at 4.5% semiannual rate……… 18.40158Semiannual interest payment…………………………………… × $ 9,000,000 165,614,220Proceeds of bond issue………………………………………… $191,403,720
On July 1, 2014, Bryant Industries Inc. issued $100,000,000 of 20-year, 9% bonds at a market (effective) interest rate of 10%, receiving cash of $91,420,905. Interest on the bonds is payable semiannually on December 31 and June 30. The fiscal year of the company is the calendar year.Instructions1. Journalize the entry to record the amount of cash proceeds from the issuance of the bonds on July 1, 2014.2. Journalize the entries to record the following:a. The first semiannual interest payment on December 31, 2014, and the amortization of the bond discount, using the straight-line method. (Round to the nearest dollar.)b. The interest payment on June 30, 2015, and the amortization of the bond discount, using the straight-line method. (Round to the nearest dollar.)3. Determine the total interest expense for 2014.4. Will the bond proceeds always be less than the face amount of the bonds when the contract rate is less than the market rate of interest?5. (Appendix 1) Compute the price of $91,420,905 received for the bonds by using the present value tables in Appendix A at the end of the text. (Round to the nearest dollar.)Answer:
1. Cash 91,420,905Discount on Bonds Payable 8,579,095Bonds Payable 100,000,0002. a. Interest Expense 4,714,477Discount on Bonds Payable* 214,477Cash 4,500,000* $8,579,095 ÷ 40 semiannual paymentsb. Interest Expense 4,714,477Discount on Bonds Payable* 214,477Cash 4,500,000* $8,579,095 ÷ 40 semiannual payments3. $4,714,4774. Yes. Investors will not be willing to pay the face amount of the bonds when theinterest payments they will receive from the bonds are less than the amount ofinterest that they could receive from investing in other bonds.5. Present value of $1 for 40 semiannualperiods at 5.0% semiannual rate………………………… 0.14205Face amount of bonds………………………………………Present value of annuity of $1 for 40× $100,000,000 $14,205,000semiannual periods at 5.0% semiannual rate………… 17.15909Semiannual interest payment……………………………… × $ 4,500,000 77,215,905Proceeds of bond issue…………………………………… $91,420,905
The following transactions were completed by Navarez Inc., whose fiscal year is the calendar year:2014July 1. Issued $88,000,000 of 10-year, 10% callable bonds dated July 1, 2014, at a market (effective) rate of 12%, receiving cash of $77,906,048. Interest is payable semiannually on December 31 and June 30.Oct. 1. Borrowed $240,000 by issuing a five-year, 5% installment note to Setzer Bank. The note requires annual payments of $55,434, with the first payment occurring on September 30, 2015.Dec. 31. Accrued $3,000 of interest on the installment note. The interest is payable on the date of the next installment note payment.31. Paid the semiannual interest on the bonds. The bond discount is amortized annually in a separate journal entry.31. Recorded bond discount amortization of $504,698, which was determined using the straight-line method.31. Closed the interest expense account.2015June 30. Paid the semiannual interest on the bonds. The bond discount is amortized annually in a separate journal entry.Sept. 30. Paid the annual payment on the note, which consisted of interest of $12,000 and principal of $43,434.Dec. 31. Accrued $2,457 of interest on the installment note. The interest is payable on the date of the next installment note payment.31. Paid the semiannual interest on the bonds. The bond discount is amortized annually in a separate journal entry.31. Recorded bond discount amortization of $1,009,396, which was determined using the straight-line method.31. Closed the interest expense account.2016June 30. Recorded the redemption of the bonds, which were called at 97. The balance in the bond discount account is $8,075,160 after payment of interest and amortization of discount have been recorded. (Record the redemption only.)Sept.30. Paid the second annual payment on the note, which consisted of interest of $9,828 and principal of $45,606.Instructions1. Journalize the entries to record the foregoing transactions.2. Indicate the amount of the interest expense in (a) 2014 and (b) 2015.3. Determine the carrying amount of the bonds as of December 31, 2015.Answer:
1. 2014July 1 Cash 77,906,048Discount on Bonds Payable 10,093,952Bonds Payable 88,000,000Oct. 1 Cash 240,000Notes Payable 240,000Dec. 31 Interest Expense 3,000Interest Payable 3,00031 Interest Expense 4,400,000Cash 4,400,00031 Interest Expense 504,698Discount on Bonds Payable 504,69831 Income Summary 4,907,698Interest Expense 4,907,6982015June 30 Interest Expense 4,400,000Cash 4,400,000Sept. 30 Interest Expense 9,000Interest Payable 3,000Notes Payable 43,434Cash 55,434Dec. 31 Interest Expense 2,457Interest Payable 2,45731 Interest Expense 4,400,000Cash 4,400,00031 Interest Expense 1,009,395Discount on Bonds Payable 1,009,39531 Income Summary 9,820,852Interest Expense 9,820,8522016June 30 Bonds Payable 88,000,000Loss on Redemption of Bonds 5,435,160Discount on Bonds Payable 8,075,160Cash* 85,360,000* $88,000,000 × 0.972016Sept. 30 Interest Expense 7,371Interest Payable 2,457Notes Payable 45,606Cash 55,4342. a. 2014: $4,907,698b. 2015: $9,820,8533. Initial carrying amount of bonds…………………………………………………… $77,906,048Discount amortized on December 31, 2014…………………………………… 504,698Discount amortized on December 31, 2015……………………………………… 1,009,395Carrying amount of bonds, December 31, 2015………………………………… $79,420,141
On July 1, 2014, Bryant Industries Inc. issued $100,000,000 of 20-year, 9% bonds at a market (effective) interest rate of 10%, receiving cash of $91,420,905. Interest on the bonds is payable semiannually on December 31 and June 30. The fiscal year of the company is the calendar year.Instructions1. Journalize the entry to record the amount of cash proceeds from the issuance of the bonds.2. Journalize the entries to record the following:a. The first semiannual interest payment on December 31, 2014, and the amortization of the bond discount, using the interest method. (Round to the nearest dollar.)b. The interest payment on June 30, 2015, and the amortization of the bond discount, using the interest method. (Round to the nearest dollar.)3. Determine the total interest expense for 2014.Answer:
1. 2014July 1 Cash 91,420,905Discount on Bonds Payable 8,579,095Bonds Payable 100,000,000
2. a. 2014Dec. 31 Interest Expense* 4,571,045Discount on Bonds Payable 71,045Cash 4,500,000*$91,420,905 × 5.0%b. 2015June 30 Interest Expense* 4,574,598Discount on Bonds Payable 74,598Cash 4,500,000
*($91,420,905 + $71,045) × 5.0%3. $4,571,045
Three different plans for financing an $80,000,000 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 39% Bonds — — $40,000,000Preferred 5% stock, $25 par __ $40,000,000 20,000,000Common stock, $20 par $80,000,000 40,000,000 20,000,000Total $80,000,000 $80,000,000 $80,000,000Instructions1. Determine for each plan the earnings per share of common stock, assuming that the income before bond interest and income tax is $10,000,000.2. Determine for each plan the earnings per share of common stock, assuming that the income before bond interest and income tax is $6,000,000.3. Discuss the advantages and disadvantages of each plan.Answer:
1. Plan 1 Plan 2 Plan 3Earnings before interest and income tax……… $10,000,000 $10,000,000 $10,000,000Deduct interest on bonds………………………… 0 0 3,600,000Income before income tax………………………… $10,000,000 $10,000,000 $ 6,400,000Deduct income tax…………………………………… 4,000,000 4,000,000 2,560,000Net income…………………………………………… $ 6,000,000 $ 6,000,000 $ 3,840,000Dividends on preferred stock…………………… 0 2,000,000 1,000,000Available for dividends on common stock…… $ 6,000,000 $ 4,000,000 $ 2,840,000Shares of common stock outstanding…………… ÷ 4,000,000 ÷ 2,000,000 ÷ 1,000,000Earnings per share on common stock…………… $ 1.50 $ 2.00 $ 2.842. Plan 1 Plan 2 Plan 3Earnings before interest and income tax……… $6,000,000 $6,000,000 $6,000,000Deduct interest on bonds………………………… 0 0 3,600,000Income before income tax………………………… $6,000,000 $6,000,000 $2,400,000Deduct income tax………………………………… 2,400,000 2,400,000 960,000Net income…………………………………………… $3,600,000 $3,600,000 $1,440,000Dividends on preferred stock……………………… 0 2,000,000 1,000,000Available for dividends on common stock……… $3,600,000 $1,600,000 $ 440,000Shares of common stock outstanding………… ÷4,000,000 ÷2,000,000 ÷1,000,000Earnings per share on common stock………… $ 0.90 $ 0.80 $ 0.443. The principal advantage of Plan 1 is that it involves only the issuance of commonstock, 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 tocommon shareholders than is Plan 2 or 3 if earnings before interest and incometax is $6,000,000. In this case, it has the largest EPS ($0.90). The principaldisadvantage of Plan 1 is that, if earnings before interest and income tax is$10,000,000, it offers the lowest EPS ($1.50) on common stock.The principal advantage of Plan 3 is that less investment would need to be madeby common shareholders. Also, it offers the largest EPS ($2.84) if earnings beforeinterest and income tax is $10,000,000. Its principal disadvantage is that the bondscarry a fixed annual interest charge and require the payment of principal. It alsorequires a dividend payment to preferred stockholders before a common dividendcan be paid. Finally, Plan 3 provides the lowest EPS ($0.44) if earnings before interestand income tax is $6,000,000.Plan 2 provides a middle ground in terms of the advantages and disadvantagesdescribed in the preceding paragraphs for Plans 1 and 3.
