Question

Analyzing alternative plans to raise money

SB Electronics is considering two plans for raising \(4,000,000 to expand operations.

Plan A is to issue 9% bonds payable, and plan B is to issue 500,000 shares of common

stock. Before any new financing, SB Electronics has net income of \)350,000 and

300,000 shares of common stock outstanding. Management believes the company can

use the new funds to earn additional income of $700,000 before interest and taxes.

The income tax rate is 30%. Analyze the SB Electronics situation to determine which

plan will result in higher earnings per share. Use Exhibit 12-6 as a guide.

Short answer

Plan A is better than plan B. Hence, issuing bonds payable is better than issuing common stock.

Step-by-step solution

Definition of the net income

The net income is the income that remains after deducting all expenses and income tax.

Calculation of earnings per share

	Plan 1	Plan 2
Net Income before the new project	$350,000	$350,000
Expected income of new project before interest and taxes	$700,000	$700,000
Less: Interest Expense	($360,000)	$0
Project income before tax	$340,000	$700,000
Less: Income tax expense (30%)	($102,000)	($210,000)
Project Net Income	$238,000	$490,000
Net Income with the new project	$588,000	$840,000
Earning per share with a new project:
Plan 1 ($588,000/300,000)	1.96
Plan 2 ($840,000/800,000)		1.05