The CFO of Daves Industries plans to have the company issue $300 million of a ne

Question

The CFO of Daves Industries plans to have the company issue $300 million of a new common stock and use the proceeds to pay off some of its outstanding bonds that carry a 7% interest rate. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT)and its tax rate all remain constant. Which of the following would occur?

A. The company’s taxable income would fall.

B. The company’s interest expense would remain constant.

C. The company would have less common equity than before.

D. The company’s net income would increase.

E. The company would have to pay less taxes.

And why?

Explanation / Answer

THE ANSWER IS : D : THE COMPANY'S NET INCOME WOULD INCREASE

WHEN THE COMPANY PAYS OFF SOME OF THE EXISTING DEBT, THE INTEREST EXPENSES WILL BE LOWER THAN WAHT IT WAS EARLIER.

LOWER INTEREST WILL LEAD TO HIGHER INCOME BEFORE TAX,

E.g., EBIT = $100 MILLION, DEBT =$ 600 MILLION

THEN PRESENT SITUATION : EBT = EBIT - INTEREST = $100 - ($600 X 7%) = $58 MILLION

NOW SAY COMPANY PAYS OFF $300 MILLION OF DEBT FROM ISSUE OF SHARES

DEBT WILL STAND AT NOW = $600 -$300 = $300 MILLION

NOW EBT = $100 - ($300 X 7%) = $79 MILLION

SEE INCOME BEOFRE TAX HAS INCREASED, THAT IS NET INCOME WILL INCREASE

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