Question

In: Accounting

Your Company needs $10,000,000 for a plant expansion. You can obtain the funds by either issuing...

Your Company needs $10,000,000 for a plant expansion. You can obtain the funds by either issuing common stock or issuing bonds. Common stock is currently trading at $100 per share and the effective rate for bonds is 5%. What factors should be considered in making this decision? What decision will you make?

Does your response change if stock is trading at $10,000 per share and interest rates are 15%?

Your response must be a minimum of 50 words.

Solutions

Expert Solution

Answer part 1  

Common stock is currently trading at $100 per share and the effective rate for bonds is 5%​

It is advisable to consider issue of bonds instead of common stock in order to obtain fund.

Factors / Reasons to consider for decision making :

  • Since company needs $10,000,000 & common stock is currently trading at $100 per share that means the company will have to issue 100,000 shares in oder to meet its requirement.
  • Thus the common stock base will increase by 100,000 shares which ultimately decreases the EPS for stockholders drastically . This may futher dilute the market value of the stock.
  • Moreover funding through issuing common stock will not provide any tax benifit .
  • On the other hand issuing bonds will provide a financial leverage to the company & since interest rate of bonds is only 5% , it will increse the oerall profitability of the company without compromising with its capital base.
  • Interest on bonds are tax deductiable thus it will decrese the overall cost.

Answer Part 2

Common stock is trading at $10,000 per share and interest rates are 15%

In this situation it is advisable to consider issue of common stock instead of bonds in order to obtain fund.

Factors / Reasons to consider for decision making :

  • Since the market value of the stock is $10,000 that means company have to issue just 1,000 shares in order to meet the fund requirement . Thus in this case number of outstanding stock will not increse drastically & EPS will not drop down extremely
  • Since the bond interest rate is 15 % which is very high . Even though interest is tax deductible but such high rate of interest will anyways increses the overall expense of the company.
  • Again if common stock are issued , the company is not eligible to pay dividends to its stockholders on regular basis unlike in the case of bonds , the interest of which should be paid regularly as per the aggrement.

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