Survey of Accounting chapter 8 problem 6 Three different plans for financing a $
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Question
Survey of Accounting chapter 8 problem 6
Three different plans for financing a $5,000,000 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
8% bonds — — $2,500,000
Preferred 4% stock, $100 par — $2,500,000 1,250,000
Common stock, $5 par $5,000,000 2,500,000 1,250,000
Total $5,000,000 $5,000,000 $5,000,000
1. Determine for each plan the earnings per share of common stock, assuming that the income before bond interest and income tax is $1,000,000.
2. Determine for each plan the earnings per share of common stock, assuming that the income before bond interest and income tax is $300,000.
3. Discuss the advantages and disadvantages of each plan.
Explanation / Answer
1. Earning per share = Net Income - Preferred Dividend / Average Outstanding Common shares
PLAN 1
Net Income = Income before tax - tax = 1,000,000 - 4,00,000 = 6,00,000
EPS = 6,00,000 - 0 / 1,000,000 = 0.6
PLAN 2
Net Income = Income before tax - tax = 1,000,000 - 4,00,000 = 6,00,000
Preffered Dividend = 4% of 2,500,000
EPS = 6,00,000 - 1,00,000 / 5,00,000 = $1
PLAN3
Net Income = Income before interest and tax - interest - tax = 1,000,000 - 2,00,000 - 3,20,000 = 4,80,000
Preffered Dividend = 4% of 1,250,000 = 50,000
EPS = 4,80,000 - 50,000 / 2,50,000 = $1.72
2.
PLAN 1
Net Income = Income before tax - tax = 300,000 - 1,20,000 = 1,80,000
EPS =1,80,000 - 0 / 1,000,000 = 0.18
PLAN 2
Net Income = Income before tax - tax = 300,000 - 1,20,000 = 1,80,000
Preffered Dividend = 4% of 2,500,000
EPS = 1,80,000 - 1,00,000 / 5,00,000 = $0.16
PLAN3
Net Income = Income before interest and tax - interest - tax = 300,000 - 2,00,000 - 40,000 = 60,000
Preffered Dividend = 4% of 1,250,000 = 50,000
EPS = 60,000 - 50,000 / 2,50,000 = $0.04
3. The higher the EPS the better it is. A higher EPS shows higher earnings, strong financial position and, therefore, a reliable company to invest money.
In Plan A company has invested whole sum in equity which has lower EPS
In Plan B company has invested partially in equity and preference as a result EPS increases
In Plan C company has invested in equity, preference shares and bonds as a result has higher EPS .
Therefore, it is better to choose Plan C which shows stronger financial position of a company.
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