Question

3. Sydney Rangers Inc operates remote parking lots near major airports. The board of directors of this family-owned company believes that Sydney Rangers could earn an additional $2 million income before interest and taxes by expanding into new markets. However, the $5 million that the business needs for growth cannot be raised within the family. The directors, who strongly wish to retain family control of the company, must consider issuing securities to outsiders.
Sydney Rangers’s Plan 1 is to borrow at 6%. Plan 2 is to issue 100,000 common shares. Plan 3 is to issue 100,000 non-voting, $3.75 preferred shares ( $3.75 is the annual dividend paid on each preferred share). Sydney Rangers currently has net income of $3.5 million and 1 million common shares outstanding. The company’s income tax rate is 25%.
Requirements:
1. Prepare an analysis to determine which plan will result in the highest earning per common share.
2. Recommend one plan to the board of directors. Explain your reasons.

Answer 1

(1) We have 3 plans to raise funds-

Plan 1- Borrow funds @6%

Plan 2-Issue common shares

Plan 3-Issue preferred shares

Working notes-

(1) current net income= $3.5 million

Tax rate- 25%

This income is after tax,for simplify the calculation convert it to before tax i.e.

= $3.5 million/(1-tax rate)

=$3.5 million/(1-.25)

=$4.67 million

(2) additional income by expending markets before interest and taxes= $2 millions

Total income before interest and taxes= $4.67 million + $2 million

= $6.67 million

Analysis of plans-

Plan A- Borrow@6%

EBIT $6.67 Million

-interest $0.3 Million

EBT $6.37 Million

- Tax@25% $1.6 Million

EAT $4.77 Million

EPS= EAT/ No. Of shareholders

EPS=$4.77 Million/1Million

EPS=$4.77

Plan B- issue 100000 common shares

EBIT $6.67 Million

-Interest -

EBT $6.67 Million

-Tax@25% $1.67 Million

EAT $5.00 Million

EPS= EAT/ No. Of shareholders

EPS=$5Million/1.1Million

EPS=$4.55

Plan C- issue 100000 preferred shares

EBIT $6.67Million

-Interest -

EBT $6.67Million

-Tax@25% $1.67Million

EAT $5.00Million

Dividend paid to preference share holder=$3.75×100000= $.375Million

EAT=$5Million - $.375Million = $4.625Million

EPS= EAT/No. Of shareholders

EPS=$4.625Million/1Million

EPS=$4.625

EPS Under three plans

PlanA planB plan C

EPS $4.77 $4.55 $4.625

Analysis- Plan A is providing highest earning per share.

(2) we will recommend plan A to Board of directors

(a) It is providing highest earning per share.

(b) Existing shareholder percentage is not changed.

(C) No preference dividend obligation is there.