Question

Blossom Company is considering these two alternatives for financing the purchase of a fleet of airplanes.

1.		Issue 51,000 shares of common stock at $40 per share. (Cash dividends have not been paid nor is the payment of any contemplated.)
2.		Issue 11%, 10-year bonds at face value for $2,040,000.

It is estimated that the company will earn $801,000 before interest and taxes as a result of this purchase. The company has an estimated tax rate of 30% and has 90,500 shares of common stock outstanding prior to the new financing.

Determine the effect on net income and earnings per share for issuing stock and issuing bonds. Assume the new shares or new bonds will be outstanding for the entire year. (Round earnings per share to 2 decimal places, e.g. $2.66.)

Answer 1

Particulars	Alternative 1 - Issue of stock	Alternative 2 -Issue bonds
Net income before interest and taxes	$801000	$801000
Less:Interest Expense	-	($224400)
Net income before taxes	$801000	$576600
Less: Tax @ 30%	($240300)	($172980)
Net income after tax (A)	$560700	$403620
No.of shares Outstanding (B)	141500	90500
Earnings per share (A/B)	$3.96	$4.46

Interest Expense in alternative 2 =$2040000 x 11% =$224400

Total no.of shares outstanding for Alternative- 1 = 90500+ 51000= 141500 shares

By issuance of common stock there is no contemplation to pay dividends, hence the net income after taxes under Alternative -1 is higher than Alternative -2.However issue of more shares certainly reduces the Earnings Per Share (EPS), hence the EPS under Alternative -1 is lower than Alternative -2.