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.

ekkarill92 answered 1 year ago

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