Question

Effect of Financing on Earnings Per Share

Three different plans for financing an $5,000,000 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		_		_		$2,500,000
Preferred 5% stock, $80 par		_		$2,500,000		1,250,000
Common stock, $5 par		$5,000,000		2,500,000		1,250,000
	Total	$ 5,000,000		$ 5,000,000		$ 5,000,000

Required:

1. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is $10,000,000. Enter answers in dollars and cents, rounding to the nearest cent.

	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 $4,750,000. Enter answers in dollars and cents, rounding to the nearest cent.

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

Answer 1

1. Determination of the earnings per share of common stock for each plan with earnings before interest and tax as $10,000,000:

	Plan 1	Plan 2	Plan 3
Income Before Interest and Taxes	$10,000,000	$10,000,000	$10,000,000
Less: Interest 10% x $2,500,000	0	0	$250,000
Income Before Taxes	$10,000,000	$10,000,000	$9,750,000
Income tax at 40%	$4,000,000	$4,000,000	$3,900,000
Profit after tax	$6,000,000	$6,000,000	$5,850,000
Less: Preference dividend	$0	$125,000	$62,500
Net Income	$6,000,000	$5,875,000	$5,787,500
Number of shares outstanding	1,000,000	500,000	250,000
Earnings per share	$6	$11.75	$23.15

EPS rounded off to nearest dollar –

Plan1 = $6

Plan2 = $12

Plan3 = $23

1. Interest on bond = 10% x $2,500,000 = $250,000
2. Preference dividend –

Plan2 = 5% x $2,500,000 = $125,000

Plan3 = 5% x $1,250,000 = $62,500

1. Number of shares outstanding –

Plan1 = $5,000,000/$5 = 1,000,000

Plan2 = $2,500,000/$5 = 500,000

Plan3 = $1,250,000/$5 = 250,000

1. EPS = net income/number of shares outstanding

Plan1 = $6,000,000/1,000,000 = $6 per share

Plan2 = $5,875,000/500,000 = $11.75 per share

Plan3 = $5,787,500/250,000 = $23.15 per share

1. Determination of EPS for three financing plans with earnings before interest and tax as $4,750,000:

	Plan 1	Plan 2	Plan 3
Income Before Interest and Taxes	$4,750,000	$4,750,000	$4,750,000
Less: Interest 10% x $2,500,000	0	0	$250,000
Income Before Taxes	$4,750,000	$4,750,000	$4,500,000
Income tax at 40%	$1,900,000	$1,900,000	$1,800,000
Profit after tax	$2,850,000	$2,850,000	$2,700,000
Less: Preference dividend	$0	$125,000	$62,500
Net Income	$2,850,000	$2,725,000	$2,637,500
Number of shares outstanding	1,000,000	500,000	250,000
Earnings per share	$2.85	$5.45	$10.55
EPS rounded off	$3	$5	$11

1. Interest on bond = 10% x $2,500,000 = $250,000
2. Preference dividend –

Plan2 = 5% x $2,500,000 = $125,000

Plan3 = 5% x $1,250,000 = $62,500

1. Number of shares outstanding –

Plan1 = $5,000,000/$5 = 1,000,000

Plan2 = $2,500,000/$5 = 500,000

Plan3 = $1,250,000/$5 = 250,000

1. EPS = net income/number of shares outstanding

Plan1 = $2,850,000/1,000,000 = $2.85 per share

Plan2 = $2,725,000/500,000 = $5.45 per share

Plan3 = $2,637,500/250,000 = $10.55 per share