Question

Assume that Tesla decides to launch a new website to market discount bookkeeping services to consumers. This chain, named Aladin, requires \(500,000 of start-up capital. The founder contributes \)375,000 of personal assets in return for 15,000 shares of common stock, but he must raise another \(125,000 in cash. There are two alternative plans for raising the additional cash.

• Plan A is to sell 3,750 shares of common stock to one or more investors for \)125,000 cash.

• Plan B is to sell 1,250 shares of cumulative preferred stock to one or more investors for \(125,000 cash

(this preferred stock would have a \)100 par value, an annual 8% dividend rate, and be issued at par).

1. If the new business is expected to earn $72,000 of after-tax net income in the first year, what rate of return on beginning equity will the founder earn under each alternative plan? Which plan will provide the higher expected return?

Short answer

Plan A and B's return on beginning equity is15.36%and16.53%,respectively.

Step-by-step solution

Definition of Return on Equity

The ratio of a company's net income to its shareholders' equity is known as return on equity (ROE).

Computation of rate of return on beginning equity for plan A

$$\begin{gathered} Returnonbeginningequity=\frac{NetIncome-Sharetooutsideinvestors}{ValueofbeginningEquity} \\ =\frac{\$72,000-\$14,400}{\$375,000} \\ =0.1536or15.36\% \end{gathered}$$

Working note:

Calculation of total number of shares issued

Number of shares issued is 18,750 i.e., (15,000+3,750)

Calculation of share of outside investor

$$\begin{gathered} Shareofoutsideinvestor=Aftertaxnetincome\times \frac{Numberofadditionalcommanstock}{Totalissuedcommanstock} \\ =\$72,000\times \frac{3,750}{18,750} \\ =\$14,400 \end{gathered}$$

Computation of rate of return on beginning equity for plan B

$$\begin{gathered} Returnonbeginningequity=\frac{NetIncome-PreferenceDividend}{ValueofbeginningEquity}\times 100 \\ =\frac{\$72,000-\$10,000}{\$375,000}\times 100 \\ =0.1653or16.53\% \end{gathered}$$

Working note:

$$\begin{gathered} Preferencedividend=\$125,000\times 8\% \\ =\$10,000 \end{gathered}$$

Plan B will provide a higher expected return.