Question

A common problem facing any business entity is the debt versus equity decision. When funds are required to obtain assets, should debt or equity financing be used? This decision also is faced when a company is initially formed. What will be the mix of debt versus equity in the initial capital structure? The characteristics of debt are very different from those of equity as are the financial implications of using one method of financing as opposed to the other.

Cherokee Plastics Corporation is formed by a group of investors to manufacture household plastic products. Their initial capitalization goal is $50,000,000. That is, the incorporators have decided to raise $50,000,000 to acquire the initial assets of the company. They have narrowed down the financing mix alternatives to two:

1. All equity financing

2. $20,000,000 in debt financing and $30,000,000 in equity financing

No matter which financing alternative is chosen, the corporation expects to be able to generate a 10% annual return, before payment of interest and income taxes, on the $50,000,000 in assets acquired. The interest rate on debt would be 8%. The effective income tax rate will be approximately 25%.

Alternative 2 will require specified interest and principal payments to be made to the creditors at specific dates. The interest portion of these payments (interest expense) will reduce the taxable income of the corporation and hence the amount of income tax the corporation will pay. The all-equity alternative requires no specified payments to be made to suppliers of capital. The corporation is not legally liable to make distributions to its owners. If the board of directors does decide to make a distribution, it is not an expense of the corporation and does not reduce taxable income and hence the taxes the corporation pays.

Required:

1. Prepare abbreviated income statements that compare first-year profitability for each of the two alternatives.

2. Which alternative would be expected to achieve the highest first-year profits?

3. Which alternative would provide the highest rate of return on equity?

4. Which alternative is considered to be riskier, all else equal?

DEBT versus EQUITY Comparative Income for Two Financing Alternatives Alternative 1 1 Alternative 2 Income before interest and taxes Less: Interest Income before taxes Less: Income taxes Net Income

Answer 1

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A B с D E 1 2 Debt Equity Alternative 1 Alternative 2 0 20000000 50000000 30000000 3 4 5 6 7 8 1 Debt Versus Equity Comparative income for two financing Alternatives Particulars Alternative 1 Alternative 2 Income before interest and taxes 50000000 50000000 Less: Interest 0 1600000 Income before taxes 50000000 48400000 Less Income taxes 12500000 12100000 Net income 37500000 36300000 9 10 11 12 13 14 37500000 Alternative 1 2 Highest first-year profits 3 Highest Rate of return on Equity 15 16 17 Alternative 1 Alternative 2 37500000 36300000 50000000 30000000 75% 121% Net income Equity Rate of return 18 19 20 21 Highest Rate of return on Equity 121% Alternative 2 22 23 Alternative 2 4 Riskier Alternative Since it is an debt alternative 24 25 Sheet205 Sheet206 Sheet207 Sheet208 Sheet209 Sheet210 Sheet211 Sheet2 Ready

For calculation ref:

4 6 A B D 1 Alternative 1 Alternative 2 2 Debt 0 20000000 3 Equity 50000000 30000000 4 5 1 Debt Versus Equity Comparative income for two financing Alternatives 7 Particulars Alternative 1 Alternative 2 8 Income before interest and taxes 50000000 50000000 Less: Interest 0 =D2*8% 10 Income before taxes =C8-C9 =D8-D9 11 Less Income taxes =C10*25% =D10*25% 12 Net income =C10-C11 =D10-D11 13 14 2 Highest first-year profits =MAX(C12:012) =IF(C14=C12,C7,07) 15 3 Highest Rate of return on Equity 16 Alternative 1 Alternative 2 17 Net income =C12 =D12 18 Equity 50000000 30000000 19 Rate of return =C17/018 =D17/D18 20 21 Highest Rate of return on Equity=MAX(C19:019) =1F(C21=C19,016,016) 22 23 4 Riskier Alternative Alternative 2 24 Since it is an debt alternative Sheet205 Sheet206 Sheet207 Sheet208 Sheet209 Sheet210 Ready 25 She