Question

) Reuth  Corporation plans to raise $2 million to pay off its existing short-term bank loan of $600,000 and to increase total assets by $1,400,000.  The bank loan bears an interest rate of 10 percent. The company's president owns 51.5% percent of the 4,000,000 shares of common stock and wishes to maintain control of the company. The company's tax rate is 20 percent.  Balance sheet information is shown below.  

The company is considering two alternatives to raise the $2 million: (1) sell common stock at $10 per share, or (2) Sell bonds at a 10 percent coupon, each $1,000 bond carrying 50 warrants to buy common stock at $15 per share.  

Current Balance Sheet
			Current Liabilities	$900,000
			Common Stock, Par $0.25	1,000,000
			Retained earnings	700,000
Total Assets	$2,600,000		Total claims	$2,600,000
Alternative 1: Common stock	$10		FACTS		Alternative 1: Common stock
# new shares	200,000		Tax rate	20%	# new shares
Par value per share	$0.25		New financing	$2,000,000	Par value per share
			Existing Loan	$600,000
Alternative 2: Debentures			Interest rate	10%	Alternative 2: Debentures
Exercise price per warrant	$15		Interest amount - old	$60,000	Exercise price per warrant
# bonds to raise new capital	2,000		Interest amount - new	$200,000	# bonds to raise 2M
# new shares	100,000				# new shares
warrants per bond	50		President owns	51.5%	warrants per bond
New money raised	1,500,000		Shares outstanding	4,000,000	New money raised
Addition to par	25,000				Addition to par
Additional paid-in capital	1,475,000				Additional paid-in capital

a.  Show the new balance sheet under both alternatives.  For Alternatives 2, show the balance sheet after  exercise of the warrants.

b.  Calculate the president's ownership position for both alternatives.  He doesn't buy any of the additional shares.

c.  Calculate earnings per share for both alternatives, assuming that EBIT is 11% of total assets.

d. Calculate the debt ratio under both alternatives

e. Which alternative do you recommend and why?

Answer 1

Answers:

a.      The calculation of new balance sheet under both the alternatives is as follows:

Formula showing above calculation is as follows:

b.      The calculation of president's ownership position for both alternatives is as follows:

Formula showing above calculation is as follows

c.      The calculation of earnings per share for both the alternatives is as follows:

Formula showing above calculation is as follows:

d. Debt ratio = Total liability / Total asset

Alternative-1 = $300,000 / $4,000,000

                     = 7.5%

Alternative-2 = ($300,000 + $4,000,000) / $7,500,000

                     = 57.33

.

e. Alternative-2 is better option as helps to control ownership through EPS is lower and debt ratio is higher.