Plan 1 Plan 2 Plan 3
8% Bonds — — $ 9,000,000
Preferred 4% stock, $20 par — $ 9,000,000 4,500,000
Common stock, $10 par $18,000,000 9,000,000 4,500,000
Total $18,000,000 $18,000,000 $18,000,000
Instructions
1. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is $2,100,000.
2. Determine the earnings per share of common stock for each plan, assuming that the income before bond interest and income tax is $1,050,000.
3. Discuss the advantages and disadvantages of each plan.
Answer:
1. Plan 1 Plan 2 Plan 3
Earnings before interest and income tax…… $2,100,000 $2,100,000 $2,100,000
Deduct interest on bonds……………………… 0 0 720,000
Income before income tax…………………… $2,100,000 $2,100,000 $1,380,000
Deduct income tax……………………………… 840,000 840,000 552,000
Net income……………………………………… $1,260,000 $1,260,000 $ 828,000
Dividends on preferred stock………………… 0 360,000 180,000
Available for dividends on common stock…
Shares of common stock outstanding………
$1,260,000
÷1,800,000
$ 900,000
÷ 900,000
$ 648,000
÷ 450,000
Earnings per share on common stock……… $ 0.70 $ 1.00 $ 1.44
2. Plan 1 Plan 2 Plan 3
Earnings before interest and income tax…… $1,050,000 $1,050,000 $1,050,000
Deduct interest on bonds……………………… 0 0 720,000
Income before income tax……………………… $1,050,000 $1,050,000 $ 330,000
Deduct income tax……………………………… 420,000 420,000 132,000
Net income………………………………………… $ 630,000 $ 630,000 $ 198,000
Dividends on preferred stock………………… 0 360,000 180,000
Available for dividends on common stock…
Shares of common stock outstanding………
$ 630,000
÷1,800,000
$ 270,000
÷ 900,000
$ 18,000
÷ 450,000
Earnings per share on common stock……… $ 0.35 $ 0.30 $ 0.04
3. The principal advantage of Plan 1 is that it involves only the issuance of common
stock, which does not require a periodic interest payment or return of principal,
and a payment of preferred dividends is not required. It is also more attractive to
common shareholders than is Plan 2 or 3 if earnings before interest and income tax
is $1,050,000. In this case, it has the largest EPS ($0.35). The principal disadvantage of
Plan 1 is that, if earnings before interest and income tax is $2,100,000, it offers the
lowest EPS ($0.70) on common stock.
The principal advantage of Plan 3 is that less investment would need to be made by
common shareholders. Also, it offers the largest EPS ($1.44) if earnings before interest
and income tax is $2,100,000. Its principal disadvantage is that the bonds carry a fixed
annual interest charge and require the payment of principal. It also requires a dividend
payment to preferred stockholders before a common dividend can be paid. Finally,
Plan 3 provides the lowest EPS ($0.04) if earnings before interest and income tax is
$1,050,000.
Plan 2 provides a middle ground in terms of the advantages and disadvantages
described in the preceding paragraphs for Plans 1 and 3.