Northeast Airlines is considering two alternatives for the financing of a purcha

Question

Northeast Airlines is considering two alternatives for the financing of a purchase of a fleet of airplanes. These two alternatives are:

1. Issue 62,000 shares of common stock at $46 per share. (Cash dividends have not been paid nor is the payment of any contemplated).

2. Issue 13%, 10-year bonds at par for $2,852,000.

It is estimated that the company will earn $706,000 before interest and taxes as a result of this purchase. The company has an estimated tax rate of 30% and has 83,100 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.

Plan One

Issue Stock:

Plan Two

Issue Bonds:

Income before interest and taxes $ $

Interest

Income before income taxes

Income tax expense

Net income

Outstanding shares

Earnings per share

Explanation / Answer

Option 1 has no P&L effect, so earnings will be:

Net Income Before Tax $800,000
Less Tax @ 30% $240,000

Net Income After Tax = $560,000

But the number of shares increase from 90,000 to 150,000

Therefore Earnings Per Share = ($560,000 / 150,000) $3.73

Option two carries with it an interest expense that will lower net income.

Under this scenario, the interest would be ($2,700,000 X 10%) $270,000 per year

So Net Income After tax is computed as:

Net Income Before Interest and Tax $800,000
Less Interest of $270,000

Net income Before Tax = ($800,000 - $270,000) $530,000

Less Income Tax of ($530,000 X 30%) $159,000

Net Income After Tax = ($530,000 - $159,000) $371,000

Earnings Per Share under this scenario equals ($371,000 / 90,000) $4.12

So even though scenario 2 results in much less net income, the earnings per share figure is higher by $0.39

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