Question

Effect of Financing on Earnings Per Share

Three different plans for financing an $6,300,000 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		_		_		$3,150,000
Preferred 10% stock, $40 par		_		$3,150,000		1,575,000
Common stock, $6.3 par		$6,300,000		3,150,000		1,575,000
	Total	$ 6,300,000		$ 6,300,000		$ 6,300,000

Required:

1. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is $12,600,000. Enter answers in dollars and cents, rounding to the nearest cent.

	Earnings Per Share on Common Stock
Plan 1	$ 7.56
Plan 2	$ 14.49
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 $5,985,000. Enter answers in dollars and cents, rounding to the nearest cent.

	Earnings Per Share on Common Stock
Plan 1	$ 3.59
Plan 2	$ 6.55
Plan 3	$

3. The principal advantage 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 is not required.

Answer 1

1.

	Plan 1	Plan 2	Plan 3
EBIT	12600000	12600000	12600000
Less: Interest	0	0	315000
Income before taxes	12600000	12600000	12285000
Less: Income taxes	5040000	5040000	4914000
Net income	7560000	7560000	7371000
Less: Preferred dividends	0	315000	157500
Income available for common stockholders	7560000	7245000	7213500
Number of outstanding common stock	1000000	500000	250000
	($6300000/$6.3)	($3150000/$6.3)	($1575000/$6.3)
Earnings per share $	7.56	14.49	28.85

2.

	Plan 1	Plan 2	Plan 3
EBIT	5985000	5985000	5985000
Less: Interest	0	0	315000
Income before taxes	5985000	5985000	5670000
Less: Income taxes	2394000	2394000	2268000
Net income	3591000	3591000	3402000
Less: Preferred dividends	0	315000	157500
Income available for common stockholders	3591000	3276000	3244500
Number of outstanding common stock	1000000	500000	250000
	($6300000/$6.3)	($3150000/$6.3)	($1575000/$6.3)
Earnings per share $	3.59	6.55	12.98