Question

Early in the 2020, Baladna Co. prepared an expansion plan. The plan requires an increase in in both property, plant and equipment and inventory by $190,000,000 and $10,000,000 respectively. The following three alternative financing plans have been suggested by the firm’s investment bankers:

Plan I: issue preferred stock at par.

Plan II: issue common stock at $10 per share.

Plan III: issue a 16% long-term bonds, due in 20 years, at par ($1,000).

Changes resulting from the three alternative plans give the following earnings per share (EPS): Plan A—0.73, Plan B—0.69, and Plan C—0.73. Based on this information, what are the main advantages and disadvantages of each plan?

Stockholders’ equity:

Preferred stock ($100 par, 10% cumulative, 500,000 shares

authorized and issued)                                                                           50,000

Common stock ($1 par, 200,000,000 shares authorized,

100,000,000 issued)                                                                           100,000

Premium on common stock                                                                120,000

Retained earnings                                                                               137,000

Total liabilities and stockholders’ equity                                          $600,000

Income Statement

For the Year Ended December 31, 2019

(in thousands except earnings per share)

Sales                                                                                              $936,000

Cost of sales                                                                                    671,000

Gross profit                                                                                   $265,000

Operating expenses:

Selling                                                                    $62,000

General                                                                     41,000          103,000

Operating income                                                                         $162,000

Other items:

Interest expense                                                                               20,000

Earnings before provision for income tax                                   $142,000

Provision for income tax                                                                 56,800

Net income                                                                                   $ 85,200

Earnings per share                                                                            $ 0.83

Answer 1

Effects of each plan -

Plan I: issue preferred stock at par.

EPS - 0.73

This plan is resulting in decrease in the current EPS from 0.83 to 0.73.

This is becuase of increase in the weihted avg of Shares. Issuing preffered stock will result in increased dividend liability but not an obligation to pay, as it is not interest charged even if there are no profits. However it will lead to Lquidation in the owner's holding and decision making power.

Also, it ay be noted at all the shares are authorised and issued. so to issue more preffered stock, company need to increase its authorised limit, that will further lead to outflow of cash and documentary requirements.

Plan II: issue common stock at $10 per share.

EPS - 0.69

Issue share at premium will lead to increase in reserves and can help the company in future for buyback of other purposes. It will lead to extra cashflow, however it is not easy to find buyers at premium , thus it may lead to non fulfillment of the cash requirement. Also, we can see that this plan leads to sharp fall in EPS thus affecting the shareholder's wealth.

Plan III: issue a 16% long-term bonds, due in 20 years, at par ($1,000).

EPS - 0.73

Issue of Bond will lead to obligation to pay interest on the company. There is a risk involved as no matter what, company has to make payment to its debenture holders.

However it will not affect the decision making power of the company and thus, it do not dilute the management or their decisions.