Question

Effect of Financing on Earnings Per Share

Three different plans for financing a $7,000,000 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		_		_		$3,500,000
Preferred 10% stock, $100 par		_		$3,500,000		1,750,000
Common stock, $7 par		$7,000,000		3,500,000		1,750,000
	Total	$7,000,000		$7,000,000		$7,000,000

Round the answers to nearest cent.

Instructions:

1. Determine for each plan the earnings per share of common stock, assuming that the income before bond interest and income tax is $14,000,000.

	Earnings per share of common stock
Plan 1	$ per share
Plan 2	$ per share
Plan 3	$ per share

2. Determine for each plan the earnings per share of common stock, assuming that the income before bond interest and income tax is $6,650,000.

	Earnings per share of common stock
Plan 1	$ per share
Plan 2	$ per share
Plan 3	$ per share

3. Regarding the three plans, which of the following statements is true?

Answer 1

• All working forms part of the answer
• Working

	Plan 1	Plan 2	Plan 3
Common Stock value at $7 par	$7000000	$3500000	$1750000
No. of common stock shares	1000000	500000	250000

• Earning per share of common stock = Net Income after tax available for common stock holders / No. of common stock shares.
• Answer 1

Calculation of Net Income available for common stockholders

	Plan 1	Plan 2	Plan 3
Income before bond interest	14000000	14000000	14000000
(-) Interest expense on bond	0	0	[3500000 x 10%] 350000
Income before income tax	14000000	14000000	13650000
(-) Income taxes at 40%	5600000	5600000	5460000
Income after income taxes	8400000	8400000	8190000
(-) Dividend share of preference stock	0	350000	175000
Income after tax available for common stockholders (A)	$8400000	$8050000	$8015000
No. of common stock shares (B)	1000000	500000	250000
Earning per share of common stock (A/B)	$8.4	$16.1	$32.06

• Answer 2

Calculation of Net Income available for common stockholders

	Plan 1	Plan 2	Plan 3
Income before bond interest	6650000	6650000	6650000
(-) Interest expense on bond	0	0	[3500000 x 10%] 350000
Income before income tax	6650000	6650000	6300000
(-) Income taxes at 40%	2660000	2660000	2520000
Income after income taxes	3990000	3990000	3780000
(-) Dividend share of preference stock	0	350000	175000
Income after tax available for common stockholders	$3990000	$3640000	$3605000
No. of common stock shares	1000000	500000	250000
Earning per share of common stock	$3.99	$7.28	$14.42