Question

Effect of Financing on Earnings Per Share

Three different plans for financing an $8,200,000 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		_		_		$4,100,000
Preferred 5% stock, $80 par		_		$4,100,000		2,050,000
Common stock, $8.2 par		$8,200,000		4,100,000		2,050,000
	Total	$ 8,200,000		$ 8,200,000		$ 8,200,000

Required:

1. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is $16,400,000. Enter answers in dollars and cents, rounding to two decimal places.

	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 $7,790,000. Enter answers in dollars and cents, rounding to two decimal places.

	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

Ans 1

Earning Before Interest & Tax = $16,400,000, Interest on Bond = $410,000 ($4,100,000 * 10%)

Tax Rate = 40%

EPS under Plan 1 (Common Stock)

EPS = Earnings for common shares / No. of common shares

No. of common shares = $8,200,000 / 8.2

= 1,000,000 shares

= [$16,400,000 * (1 - 0.4)] / 1,000,000

= $9.84 or 984 cents

EPS under Plan 2 (Preferred Stock & Common Stock)

EPS = Earnings for common shares / No. of common shares

No. of common shares = $4,100,000 / 8.2

= 500,000 shares

= [$16,400,000 (1 - 0.4) - ($4,100,000 * 5%)] / 500,000

= $19.27 or 1927 cents

EPS under Plan 3 (Bonds, Preferred Stock & Common Stock)

EPS = Earnings for common shares / No. of common shares

No. of common shares = $2,050,000 / 8.2

= 250,000 shares

= [($16,400,000 - $410,000)*(1 - 0.4) - (2,050,000 * 5%)] / 250,000

= $37.97 or 3797 cents

Ans 2

Earning Before Interest & Tax = $7,790,000, Interest on Bond = $410,000 ($4,100,000 * 10%)

Tax Rate = 40%

EPS under Plan 1 (Common Stock)

EPS = Earnings for common shares / No. of common shares

No. of common shares = $8,200,000 / 8.2

= 1,000,000 shares

= [$7,790,000 * (1 - 0.4)] / 1,000,000

= $4.67 or 467 cents

EPS under Plan 2 (Preferred Stock & Common Stock)

EPS = Earnings for common shares / No. of common shares

No. of common shares = $4,100,000 / 8.2

= 500,000 shares

= [$7,790,000 (1 - 0.4) - ($4,100,000 * 5%)] / 500,000

= $8.94 or 894 cents

EPS under Plan 3 (Bonds, Preferred Stock & Common Stock)

EPS = Earnings for common shares / No. of common shares

No. of common shares = $2,050,000 / 8.2

= 250,000 shares

= [($7,790,000 - $410,000)*(1 - 0.4) - (2,050,000 * 5%)] / 250,000

= $17.30 or 1730 cents