The financial statements for KB Corporation as at 31 December 2014, show the fol

Question

The financial statements for KB Corporation as at 31 December 2014, show the following information:

Balance Sheet at 31.12.2014

Assets

8,000,000

Liabilities                     

1,200,000

Stockholders’ equity : 300,000

shares 6,800,000       

Income statement for 2014

Income from operations                            

1,200,000

less interest expense               

100,000

Income before taxes

1,100,000

Less income tax expense (30%)

330,000

Net income

770,000

The levels of assets, liabilities, stockholders’ equity and operating income have been stable in recent years. However, KB Corporation is planning a £1,800,000 expansion program that will increase income from operations by £ 350,000 to £1,550,000.

KB is planning to sell 8.5% notes at par to finance the expansion.

Required:

(a) What earnings per share does KB report before the expansion?

(b) Would this use of leverage to finance the expansion be advantageous to KB's stockholders? Explain.

(c) Assume the income from operations will increase only by £150,000. Would this use of leverage be advantageous?

(d) Assume that income from operation will increase by £200,000 and that KB could also raise the required amount by issuing an additional 100,000 shares. Which means of financing would equity stockholders prefer? Please explain.

(e) Discuss what other factors KB Corporation would need to consider before deciding to expand.      

Balance Sheet at 31.12.2014

Assets

8,000,000

Liabilities                     

1,200,000

Stockholders’ equity : 300,000

shares 6,800,000       

Income statement for 2014

Income from operations                            

1,200,000

less interest expense               

100,000

Income before taxes

1,100,000

Less income tax expense (30%)

330,000

Net income

770,000

Explanation / Answer

(a). Earnings per share before expansion;

Formula for earnings per share = (Net Income / Number of shares)

Thus earnings per share = $770000 / 300000

= $2.57 per share (Approx.)

(b). Would this use of leverage to finance the expansion be advantageous to KB's stockholders?

For knowing whether use of leverage to finance the expansion is advantageous or not. We will have to check impact on net income & EPS.

So let’s calculate net income and EPS after expansion;

Income from operations

$1550000

Less: Interest expense

$253000

Income before taxes

$1297000

Less: Income tax expense @30%

$389100

Net income

$907900

Number of shares

300000

Earnings per share (EPS)

$3.03 per share

So after looking the effect of expansion on net income and on EPS, it is clear that use of leverage to finance the expansion is advantageous because it will increase net income and EPS as well.

(c). Assume the income from operations will increase only by £150,000. Would this use of leverage be advantageous?

Let’s calculate net income and EPS;

Income from operations

$1350000

Less: Interest expense

$253000

Income before taxes

$1097000

Less: Income tax expense @30%

$329100

Net income

$767900

Number of shares

300000

Earnings per share (EPS)

$2.56 per share

So after looking the effect of expansion on net income and on EPS, it is clear that use of leverage to finance the expansion is not advantageous because it will decrease net income and EPS as well.

(d). Assume that income from operation will increase by £200,000 and that KB could also raise the required amount by issuing an additional 100,000 shares. Which means of financing would equity stockholders prefer?

Let’s calculate net income and EPS;

Income from operations

$1400000

Less: Interest expense

$100000

Income before taxes

$1300000

Less: Income tax expense @30%

$390000

Net income

$910000

Number of shares

400000

Earnings per share (EPS)

$2.27 per share

So after looking the effect of expansion on net income and on EPS, it is clear that use of more shares to finance the expansion is not advantageous because it will decrease earnings per share (EPS). Althogh net income will increase but due to an increase in the number of common stock shares.

So as a result it can be said that company should use debt upto a limit because it will help in increasing earnings per share. So use of common stock shares should not be preferred.

(e). What other factors KB Corporation would need to consider before deciding to expand;

Before expansion following factors needs to be consider;

1. Market trend

2. Demand of the products & services of the company.

3. Available supply in the market.

4. Available excess capacity in the company.

5. Cost of the expansion.

6. Cost of capital needed for expansion.

7. Expected return on the capital.

8. Expectations of the owners of the company etc.

Income from operations

$1550000

Less: Interest expense

$253000

Income before taxes

$1297000

Less: Income tax expense @30%

$389100

Net income

$907900

Number of shares

300000

Earnings per share (EPS)

$3.03 per share

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