A firm with earnings before interest and taxes of $500,000 needs $1 million of a

Question

A firm with earnings before interest and taxes of $500,000 needs $1 million of additional funds. If it issues debt, the bonds will mature after 20 years and pay interest of 8 percent. The firm could issue preferred stock with a dividend rate of 8 percent. The firm has 100,000 shares of common stock outstanding and is in the 30 percent tax bracket. What are the (1) earnings per common share under the two alternatives, (2) the times-interest-earned if the firm uses debt financing, and (3) the times-dividend-earned if the firm uses preferred stock financing?

Explanation / Answer

1. Calculation of Earning Per Share:

2. Times Interest Earned Ratio:

Times Interest Earned Ratio = EBIT / Interest

= 500,000 / 80,000

Times Interest Earned Ratio = 6.25 Times

3. Times Dividend Earned Ratio:

Times Dividend Earned Ratio = Net Income / Preferred Dividend

= 350,000 / 80,000

Times Dividend Earned Ratio = 4.375 Times

Debt Alternative($) Preferred Stock($) Amount Required 1,000,000 1,000,000 Earning before Interest and Tax 500,000 500,000 Less: Interest Cost(8%) 80,000 ---- Earning After Interest 420,000 500,000 Tax(30%) 126,000 150,000 Earning After Tax 294,000 350,000 Less: Dividend to Pref. Shares 80,000 Earning Available for Common Stockholders 294,000 270,000 Earning Per Common Share 2.94 2.70

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