Kim owns all 100 shares of common stock in GBZ Co. She has decided that she need

Question

Kim owns all 100 shares of common stock in GBZ Co. She has decided that she needs to raise $10,000 in new capital this year. She is trying to decide between two alternatives that are open to her. One is to issue a $10,000 bond, paying 10 percent interest. The other is to create and sell 100 additional shares, at $100 each. Calculate what her own earnings will be next year if ABC’s profits, before interest payments, are 0, $1,000, $2,000, $3,000 or $4,000:

if she chooses bond financing.

if she chooses stock financing.

What should Kim take into account when deciding how to finance the expansion of GBZ Co?

Explanation / Answer

If Kim issues the bonds, her annual interest payment for the bond = $10,000 x 10% = $1,000

So, for bond financing her annual pre-tax earnings will decrease by $1,000.

For stock financing, the income statement will not be affected, so earnings before interest will remain unchanged.

(a) Earnings based on mode of financing

(b) However, change in earning before interest is not the sole factor for consideration. Stocks issued will require dividends to be paid each year, which will decrease the retained earnings every year. Secondly, cost of financing is lower in case of bonds than stock, since interest payable on bonds is tax deductible but dividends are not. Considering these aspects, stock financing may be the preferred mode of raising capital.

PROFITS BEFORE INTEREST ($) 0 1,000 2,000 3,000 4,000 Bond Financing -1,000 0 1,000 2,00 3,000 Stock Financing 0 1,000 2,000 3,000 4,000

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