Global Airlines is considering two alternatives for the financing of a purchase

Question

Global Airlines is considering two alternatives for the financing of a purchase of a fleet of airplanes. These two alternatives are: 1. Issue 59,625 shares of common stock at $40 per share. (Cash dividends have not been paid nor is the payment of any contemplated.) 2. Issue 8%, 10-year bonds at face value for $2,385,000. It is estimated that the company will earn $736,000 before interest and taxes as a result of this purchase. The company has an estimated tax rate of 40% and has 80,200 shares of common stock outstanding prior to the new financing. Determine the effect on net income and earnings per share for these two methods of financing.

Explanation / Answer

Hi, Please find the answers as follows: Option 1 doesnot result in any affect on P & L Statement, so earnings will be: Net Income Before Tax 736000 Less Tax @ 30% on 220800 Net Income After Tax = 515200 Number of shares have increased from 80200 to 139825 EPS= (515200/ 139825) $3.68 Option two includes interest expense that will lower down the net income Under this scenario, the interest would be (2385000 X 10%) 238500 per year Net Income After tax: Net Income Before Interest and Tax 736000 Less Interest 238500 Net income Before Tax = 497500 Less Income Tax = 497500*.40 = 199000 Net Income After Tax = 298500 Earnings Per Share (298500 / 139825) 2.13 Thanks, Aman

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