Question

Question: Analyzing alternative plans to raise money SB Electronics is considering two plans for raising $4,000,000 to expand operations. Plan A is to issue 9% bonds payable, and plan B is to issue 500,000 shares of common stock. Before any new financing, SB Electronics has net income of $350,000 and 300,000 shares of common stock outstanding. Management believes the company can use the new funds to earn additional income of $700,000 before interest and taxes. The income tax rate is 30%. Analyze the SB Electronics situation to determine which plan will result in higher earnings per share. Use Exhibit 12-6 as a guide.

 

Answer 1

 

Step 1: Definition of the net income

The net income is the income that remains after deducting all expenses and income tax.

Step 2: Calculation of earnings per share

	Plan 1	Plan 2
Net Income before the new project	$350,000	$350,000
Expected income of new project before interest and taxes	$700,000	$700,000
Less: Interest Expense	($360,000)	$0
Project income before tax	$340,000	$700,000
Less: Income tax expense (30%)	($102,000)	($210,000)
Project Net Income	$238,000	$490,000
Net Income with the new project	$588,000	$840,000
Earning per share with a new project:
Plan 1 ($588,000/300,000)	1.96
Plan 2 ($840,000/800,000)		1.05

 

 

Plan A is better than plan B. Hence, issuing bonds payable is better than issuing common stock.