Corporations: Paid-In Capital and the Balance Sheet app12

Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.

Chapter 12 Appendix

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Copyright © 2012 Pearson Education, Inc. Publishing as Prentice Hall.2

Compare issuing bonds to issuing stocks (Appendix 12A)

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Compare issuing bonds to issuing stocks(Appendix 12A)

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Issuing bonds Issuing stockMust pay interest and principal to bondholdersReduces net income

Interest expenseCan increase earnings per share

Leverage

Does not have to be “paid off”Does not affect net incomeIncreases number of shares outstandingDecreases earnings per share

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Wakeville Marina needs to raise $3,000,000 to expand. Wakeville’s president is considering two plans:

Plan A: Issue $3,000,000 of 7% bonds payable to borrow the moneyPlan B: Issue 100,000 shares of common stock at $30 per share

Before any new financing, the company expects to earn net income of $300,000, and the company already has 100,000 shares of common stock outstanding. Wakeville believes the expansion will increase income before interest and income tax by $500,000. The income tax rate is 35%.

Prepare an analysis similar to Exhibit 12A-1 to determine which plan is likely to result in higher earnings per share. Which financing plan would you recommend?

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Plan AIssue $3,000,000 of

7% bonds

Plan BIssue $3,000,000 of

Common Stock

Net income before new project $300,000 $300,000

Expected income on the new project before interest and income tax expenses

$500,000 $500,000

Less: Interest expense (210,000) 0

Project income before income tax

$290,000 $500,000

Less: Income tax expense (101,500) (175,000)

Project net income 188,500 325,000

Net income with new project 488,500 625,000

Earnings per share with new $4,89 $3.13


Companies face the following decision: How shall we finance a new project—with bonds or with stock?Borrowing by issuing bonds payable carries a risk: The company may be unable to pay off the bonds.Borrowing can increase the earnings per share, but borrowing has its disadvantages. Debts must be paid during bad years as well as good years. Interest expense may be high enough to eliminate net income and can even lead to bankruptcy.

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The earnings per one share of stock is higher if a company issues bonds. If all goes well, the company can earn more on the new project than the interest it pays on the bonds.Earning more income on borrowed money than the related interest expense is called using leverage. It is widely used to increase earnings per share of common stock.

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Business

Corporations: Paid-In Capital and the Balance Sheet app12