Assume that Kelly Giard of Clean Air Lawn Care decides to launch a new retail ch

Question

Assume that Kelly Giard of Clean Air Lawn Care decides to launch a new retail chain to market electrical mowers. This Chain, named Mow Green , requires $500,000 of start-up capital. Kelly contributes $375,000 of personal assets in return for 15,000 shares of common stock, but he must raise another $125,000 in cash. there are two alternative plans for raising additional cash. Plan A is to sell 3,750 shares of common stock to one or more investors for $125,000cash. Plan B is to sell 1,250 shares of cumulative preferred stock to one or more investors for $125,000 cash (this perferred stock would have a $100.00 par value, an annual 8% dividend rate, and be issued at par).

1. If the business is expected to earn $72,000 of the after-tax net income in the first year, what rate of return on the beginning equity will Kelly earn under each alternative plan? Which plan will provide the higher expected return?

2. If the business is expected to earn $16,800 of the after-tax net income in the first year, what rate of return on the beginning equity will Kelly earn under each alternative plan? Which plan will provide the higher expected return?

3. Analyze and interpret the differences between the results for parts 1 and 2

Explanation / Answer

Assuming all common shares have same par value            1 Plan A No of shares Value of share Price/share Kelly's own share                       15,000                            375,000                      25 Additional share issue                          3,750                            125,000                      33 Total                         18,750                            500,000 After Tax net income =                       72,000 Earning Per share= $                        3.84 Kelly return % =3.84/25= 15.36% Plan B No of shares Value of share Price/share Kelly's own share                       15,000                            375,000                      25 Cumulative preference shares $100 par ,8% dividend                            1,250                            125,000                    100 Total                            500,000 After Tax net income =                       72,000 Less Preference dividend @$8 for 1250 pref shares                       10,000 Net Earning Available for common stock=                       62,000 Earning Per share= $                        4.13 Kelly return % =4.13/25= 16.53% So Plan B gives higher return to Kelly's beginning equity            2 When PAT =16800 Plan A No of shares Value of share Price/share Kelly's own share                       15,000                            375,000                      25 Additional share issue                          3,750                            125,000                      33 Total                         18,750                            500,000 After Tax net income =                       16,800 Earning Per share= $                        0.90 Kelly return % =0.90/25= 3.58% Plan B No of shares Value of share Price/share Kelly's own share                       15,000                            375,000                      25 Cumulative preference shares $100 par ,8% dividend                            1,250                            125,000                    100 Total                            500,000 After Tax net income =                       16,800 Less Preference dividend @$8 for 1250 pref shares                       10,000 Net Earning Available for common stock=                          6,800 Earning Per share= $                        0.45 Kelly return % =0.45/25= 1.81% So Plan A gives higher return to Kelly's beginning equity

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