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.
2.
3.
As seen debt financing have advantage when internal rate of return is more than the cost of debt capital itherwise it will reduce the earnings per share of common stock in 1st part IRR is 20%(1000000/5000000)and debt cost is 8% so it increase the EPS. But in second case IRR is 6% which is less than 8%so it reduced the EPS.
Plan 1 plan2 plan3 EBIT 1000000 1000000 1000000 Less interest - - 200000 EBT 1000000 1000000 800000 Less income tax(40%) 400000 400000 320000 Net income 600000 600000 480000 Dividend on preferred stock(4%) - 100000 50000 Available for dividend on common stock 600000 500000 430000 Divided by no. Of common stock outstanding 1000000 500000 250000 Earnings per share on common stock .6 1 1.72Related Questions
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