Plan 1 Plan 2 Plan 3
9% Bonds — — $40,000,000
Preferred 5% stock, $25 par __ $40,000,000 20,000,000
Common stock, $20 par $80,000,000 40,000,000 20,000,000
Total $80,000,000 $80,000,000 $80,000,000
Instructions
1. Determine for each plan the earnings per share of common stock, assuming that the income before bond interest and income tax is $10,000,000.
2. Determine for each plan the earnings per share of common stock, assuming that the income before bond interest and income tax is $6,000,000.
3. Discuss the advantages and disadvantages of each plan.
Answer:
1. Plan 1 Plan 2 Plan 3
Earnings before interest and income tax……… $10,000,000 $10,000,000 $10,000,000
Deduct interest on bonds………………………… 0 0 3,600,000
Income before income tax………………………… $10,000,000 $10,000,000 $ 6,400,000
Deduct income tax…………………………………… 4,000,000 4,000,000 2,560,000
Net income…………………………………………… $ 6,000,000 $ 6,000,000 $ 3,840,000
Dividends on preferred stock…………………… 0 2,000,000 1,000,000
Available for dividends on common stock…… $ 6,000,000 $ 4,000,000 $ 2,840,000
Shares of common stock outstanding…………… ÷ 4,000,000 ÷ 2,000,000 ÷ 1,000,000
Earnings per share on common stock…………… $ 1.50 $ 2.00 $ 2.84
2. Plan 1 Plan 2 Plan 3
Earnings before interest and income tax……… $6,000,000 $6,000,000 $6,000,000
Deduct interest on bonds………………………… 0 0 3,600,000
Income before income tax………………………… $6,000,000 $6,000,000 $2,400,000
Deduct income tax………………………………… 2,400,000 2,400,000 960,000
Net income…………………………………………… $3,600,000 $3,600,000 $1,440,000
Dividends on preferred stock……………………… 0 2,000,000 1,000,000
Available for dividends on common stock……… $3,600,000 $1,600,000 $ 440,000
Shares of common stock outstanding………… ÷4,000,000 ÷2,000,000 ÷1,000,000
Earnings per share on common stock………… $ 0.90 $ 0.80 $ 0.44
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 $6,000,000. In this case, it has the largest EPS ($0.90). The principal
disadvantage of Plan 1 is that, if earnings before interest and income tax is
$10,000,000, it offers the lowest EPS ($1.50) 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 ($2.84) if earnings before
interest and income tax is $10,000,000. 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 ($0.44) if earnings before interest
and income tax is $6,000,000.
Plan 2 provides a middle ground in terms of the advantages and disadvantages
described in the preceding paragraphs for Plans 1 and 3.