Question

DeSoto Tools Inc. is planning to expand production. The expansion will cost \(300,000, which can be financed either by bonds at an interest rate of 14 percent or by selling 10,000 shares of common stock at \)30 per share. The current income statement before expansion is as follows:

DeSOTO TOOLS, INC.
Sales		\(1,500,000
Less: Variable cost	\)450,000
Fixed cost	550,000	1,000,000
Earning before interest and taxes		\(500,000
Less: Interest expenses		100,000
Earning before taxes		\)400,000
Less: Taxes @34%		136,000
Earning after taxes		\(264,000
Shares		100,000
Earning per shares		\)2.64

After the expansion, sales are expected to increase by \(1,000,000. Variable costs will remain at 30 percent of sales, and fixed costs will increase to \)800,000. The tax rate is 34 percent.

b. Construct the income statement for the two alternative financing plans.

Short answer

The income under alternative 1 is $170,280 and under alternative 2 is 198,000.

Step-by-step solution

Information given in the question

Alternative 1

Issue 14% bonds: $300,000

Alternative 2

Sale 10,000 shares at $30 per share

After expansion:

Sales increased by $1,000,000

Variable cost: 30% of sales

Fixed cost increased by $800,000

Income statement

	Alternative 1	Alternative 2
Sales (1,500,000+1,000,000)	$2,500,000	$2,500,000
Less: Variable cost (30% of sales)	750,000	750,000
Fixed cost (550,000+800,000)	1,350,000	1,350,000
Earning before interest and taxes	$400,000	$400,000
Less: Interest expenses	142,000 (100,000+(300,000 x 14%)	100,000
Earning before taxes	$258,000	$300,000
Less: Taxes @34%	87,720	102,000
Earning after taxes	170,280	198,000
Shares	100,000	110,000
Earning per share	1.70	1.80