Assume that Ali Loopy decides to form a corporation to launch a new retail chain

Question

Assume that Ali Loopy decides to form a corporation to launch a new retail chain to market personal coaching services. This chain, named Get A Clue Co., requires $500,000 of start-up capital. Ali contributes $200,000 of personal assets in return for 10,000 shares of common stock, but she still needs to raise another $300,000 in cash. There are two alternative plans for raising the additional cash. Plan A is to sell 15,000 shares of common stock to one or more investors for $300,000 cash. Plan B is to issue (sell) $300,000 of 10 year bonds at an annual 7% interest rate.

1. If the new business earns $80,000 before paying interest on the bonds, what rate of return on her beginning investment will Ali earn under each alternative?

2. If the new business earns $23,000 before paying interest on the bonds, what rate of return on her beginning investment will Ali earn under each alternative?

3. From Ali’s prospective what are the advantages and disadvantages of issuing bonds?

4. From Ali’s prospective what are the advantages and disadvantages of issuing common stock?

Explanation / Answer

1.

2.

3. The main advantage of issuing bonds for Ali would be leverage. Leverage can actually magnify earnings per share for common stockholders, as activity levels increase, with the equity base remaining the same. Also the overall cost of capital would decrease as debt is a cheaper source of capital as compared to equity, not least due to the benefit of the tax shield enjoyed by interest expense. Third, by issuing bonds, Ali ensures that the company keeps belonging to her, as providers of debt finance are the creditors to the company, and not owners.

Disadvantage of issuing bonds is the financial risk of the company not being able to absorb the fixed finance charges in its income stream. The principal risk is that of default in paying the interest to the bondholders, and of repayment of the principal sum when it falls due. In such a situation, the creditors can file for bankruptcy of the company.

4. Advantage of issuing common stock is that there are no fixed payments ( as per contract) required to be made to the stockholders.

But the overall cost of capital shoots up, thereby ultimately reducing return for the investors. From Ali's point of view of course she is reduced from being a 100% stockholder to a 40% stockholder.

Also, as the equity base expands, earnings per share tends to fall.

Plan A Plan B EBIT 80,000 80,000 Interest expense 0 21,000 Net income 80,000 59,000 Common stock 500,000 200,000 Rate of return 16% 29.5%

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.