Question

Book Name: Principles of Managerial Finance - 180 Day Option, 14th Edition
Lawrence J. Gitman

P2–5 Interest versus dividend expense   Michaels Corporation expects earnings before interest and taxes to be $50,000 for the current period. Assuming an ordinary tax rate of 35%, compute the firm’s earnings after taxes and earnings available for common stockholders (earnings after taxes and preferred stock dividends, if any) under the following conditions:

1. The firm pays $12,000 in interest.
2. The firm pays $12,000 in preferred stock dividends.

Please provide me with a detailed calculation for my study purpose thank you!

Answer 1

a. If the firm pays $ 12,000 in interest, we shall calculate the Earnings After Tax and Earnings Available for common stockholders as follows:

Particulars	Amount
Earnings before interest and tax	$ 50,000
Less: Interest	$ 12,000
Earnings before tax	$ 38,000
Less tax @ 35%	$ 13,300 ($ 38,000 x 35%)
Earnings after tax	$ 24,700

Since in this case there is no preference dividends, hence earnings for common stockholders will also be equal to Earnings after tax i.e. $ 24,700

b. If the firm pays $ 12,000 in preferred stock dividends, we shall calculate the Earnings After Tax and Earnings Available for common stockholders as follows:

Particulars	Amount
Earnings before interest and tax	$ 50,000
Less: Interest	$ 0
Earnings before tax	$ 50,000
Less tax @ 35%	$ 17,500 ($ 50,000 x 35%)
Earnings after tax	$ 32,500
Less Preferred dividend	$ 12,000
Earnings available for common Stockholders	$ 20,500

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