Question

Sandhill Co. is considering these two alternatives for financing the purchase of a fleet of airplanes. 1. Issue 61,000 shares of common stock at $45 per share. (Cash dividends have not been paid nor is the payment of any contemplated.) 2. Issue 14%,10-year bonds at face value for $2,745,000. It is estimated that the company will earn $821,000 before interest and taxes as a result of this purchase. The company has an estimated tax rate of 40% and has 92,100 shares of common stock outstanding prior to the new financing. Determine the effect on net income and earnings per share for issuing stock and issuing bonds. Assume the new shares or new bonds will be outstanding for the entire year. (Round earnings per share to 2 decimal places, e.g. $2.66.)

Answer 1

Issuing stock has a negative effect on net income and decreases earnings per share, while issuing bonds has a positive effect on net income and increases earnings per share.

Step-by-step explanation:

First, let's calculate the effect on net income for issuing stock and issuing bonds.

For issuing stock:

Number of new shares issued: 61,000

Stock price per share: $45

Total proceeds from issuing stock: 61,000 x $45 = $2,745,000

Earnings before interest and taxes (EBIT): $821,000

Tax rate: 40%

Net income after taxes: $821,000 x (1 - 0.4) = $492,600

Effect on net income: $492,600 - $821,000 = -$328,400

For issuing bonds:

Total proceeds from issuing bonds: $2,745,000

Interest expense (annual interest payment): 14% x $2,745,000 = $383,300

EBIT: $821,000

Tax rate: 40%

Net income after taxes: $821,000 x (1 - 0.4) = $492,600

Effect on net income: $492,600 - $383,300 = $109,300

Next, let's calculate the effect on earnings per share (EPS) for issuing stock and issuing bonds.

Current number of common shares outstanding: 92,100

Total number of shares after issuing stock: 92,100 + 61,000 = 153,100

Total number of shares after issuing bonds: 92,100

EPS for issuing stock: $492,600 / 153,100 = $3.21

EPS for issuing bonds: $492,600 / 92,100 = $5.35

Answer 2

To analyze the effects of financing through stock issuance, Sandhill Co. would see a net income of $492,600 and an EPS of $3.22. Opting for bond issuance, the net income would drop to $262,020 with an EPS of $2.84, due to the interest expenses associated with the bonds.

Step-by-step explanation:

Effect of Financing Options on Net Income and Earnings Per Share

To determine the effect on net income and earnings per share (EPS) for Sandhill Co. regarding the financing options, we will calculate the net income and EPS after issuing stock and after issuing bonds.

Issuing Stock:

Net Income after issuing stock is straightforward since no debt expense is incurred. The earnings before interest and taxes (EBIT) is $821,000. With no interest to pay, earnings before taxes are also $821,000. Applying the 40% tax rate:

Net Income = EBIT - Taxes = $821,000 - (40% of $821,000) = $821,000 - $328,400 = $492,600

Shares outstanding after issuing new stock = 92,100 + 61,000 = 153,100 shares

EPS = Net Income / Shares Outstanding = $492,600 / 153,100 = $3.22 per share (rounded to two decimal places)

Issuing Bonds:

For the bond option, there is an interest expense of 14% on the $2,745,000, which is $384,300 for the year.

Earnings after interest = $821,000 - $384,300 = $436,700
Earnings before taxes = $436,700
Applying the 40% tax rate:

Net Income = $436,700 - (40% of $436,700) = $436,700 - $174,680 = $262,020

Since no extra shares are issued, the shares outstanding remain 92,100.

EPS = Net Income / Shares Outstanding = $262,020 / 92,100 = $2.84 per share (rounded to two decimal places)