Question

The Kerlene Corporation is considering a plan in which it would increase the size of its operations. As a result of the increased operations, without considering the cost of borrowing, the company expects income before taxes to increase by $3,000,000 per year in years 1-3, and $5,000,000 per year in years 4-9. To increase its operations the company would issue $30,000,000, 11%, 9-year bonds. The company expects to be able to issue the bonds at their principal.

Calculate the Corporation's total expected 9-year increase in income before taxes after considering the cost of borrowing.

a. $3,300,000 decrease

b. $9,300,000 increase

c. $29,700,000 decrease

d. $39,000 increase

Answer 1

Solution:

Year	Income before interest and taxes	Interest on Bonds ($3,000,000*11%)	Income before tax after deducting interest on bonds
1	$3,000,000	$3,300,000	-$300,000
2	$3,000,000	$3,300,000	-$300,000
3	$3,000,000	$3,300,000	-$300,000
4	$5,000,000	$3,300,000	$1,700,000
5	$5,000,000	$3,300,000	$1,700,000
6	$5,000,000	$3,300,000	$1,700,000
7	$5,000,000	$3,300,000	$1,700,000
8	$5,000,000	$3,300,000	$1,700,000
9	$5,000,000	$3,300,000	$1,700,000
			$9,300,000

Total Expected 9 year increase in income before taxes after considering cost of borrowing = $9,300,000

Hence, the correct option is b. $9,300,000 increase

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