Question

Bagan Corporation, a profitable growth company with 200,000 shares of common stock outstanding, is in need of approximately $40 million in new funds to finance required expansion. Currently, there are no other equities outstanding. Management has three options open: a. Sell $40 million of 12‐per cent bonds at face value. b. Sell shares of 10% preferred stock: 400,000 shares at $100 each (dividend $10 per share). c. Sell another 200,000 shares of common stock at $200 each. Operating income (before interest and income taxes) on completion of the expansion is expected to average $12 million per year; the income tax rate is 50%. Required: 1. Complete the schedule below and calculate the earnings per share of common stock.   12% bonds Preferred stock Common stock Income before interest and income taxes    $12,000,000 $12,000,000    $12,000,000   Less: Interest expense     Income before taxes            Less: Income taxes at 50%          Net income            Less: Preferred dividends          Net income available to common stockholders     Number of common shares outstanding     Earnings per share of common stock          2. Which financing option is most advantageous to the common stockholders? Why?

Can someone please assist with this assignment?

Answer 1

1) Schedule

	12% bonds	Preferred stock	Common Stock
Income before interest and income taxes	12000000	12000000	12000000
Less: Interest expense	4800000	0	0
Income before taxes	7200000	12000000	12000000
Less: Income taxes at 50%	3600000	6000000	6000000
Net income	3600000	6000000	6000000
Less: Preferred dividend	0	4000000	0
Net income available to common shareholders	3600000	2000000	6000000
Number of Common Shares outstanding	200000	200000	400000
Earning per share of Common Stock	18	10	15

Option 1 issue bonds are most advantageous for the common stockholders because option 1 earning per share for common stockholders is higher than other options.

2)

Option 1, i.e., 12% Bonds, would be more advantageous for the common stockholders because the earning per share in this option is higher than the other two options. Secondly, the company would get the tax benefit on the interest paid on the bonds. Hence, the company should go for 12% bonds.