Enrietto\'s policy is to pay 60% of net income to stockholders as dividends. Enr

Question

Enrietto's policy is to pay 60% of net income to stockholders as dividends. Enrietto expects to be able to raise the $1,000,000 it needs for the acquisition by selling 50,000 shares of common stock at $20 each or by issuing $1,000,000 of 20-year, 12% bonds. Enrietto expects income from operations to grow by $700,000 after Fiberglass Products has been acquired. (Interest expense will increase if debt is used to finance the acquisition.)

Required:

1. Determine the return on equity (net income/total equity) before the acquisition and for both financing alternatives (round percentages to 2 decimal places).

2. If Enrietto sells additional stock, what will be the cash outflow for dividends?
$

3. If Enrietto sells bonds, what will be the net cash outflows for new interest and for all dividends? (Remember that interest is tax-deductible.)

4. Assume that Enrietto sells stock and that none of the preacquisition stockholders buy any of the 50,000 new shares. What total amount of dividends will the preacquisitionstockholders receive after the acquisition? Round your answers to the nearest dollar.   $

5. Which alternative is better for Enrietto's preacquisition stockholders?    (Stocks/Bonds)

The return on equity before the acquisition % The return on equity after acquisition if bonds are issued % The return on equity after acquisition if common stock is sold %

Explanation / Answer

The return on equity before the acquisition is as under: Return on equit=Net Income/Shareholders equity The return on equity before the acquisition is as under: Return on equity= $3,300,000/12,000,000                                   '=27.5% If bonds are issued then the return on equity would be as under: If bonds are issued then net income will increase by $700,000 The net income after bonds are issued is calculated as under: Income before tax $5,000,000 Income increases $700,000 Total income $5,700,000 Less: Interest expense(20% of $1,000,000) ($120,000) Net income before tax $5,820,000 Tax expense(34%) $(1,978,800) Net Income after tax $   3,841,200 The shareholders equity changes with the change in net income for the year therefore if bonds are issued the net income will increase and interest expense will also increases. The shareholders equity after issue of bond= ($12,000,000+$$700,000-$120,000-$197,200)                  '=$12,382,800 Return on equity=Net Income/Shareholders equity                                   '=$3,841,200/$12,382,800                                   '=31.02% If Acqutisition is made by issuing common stock of 50,000 shares @ $20 each, the return on equity would be as under: Shareholders equtiy after issue of 50,000 shares Common stock==($6,000,000+$1,000,000)=$7,000,000 Retained Earnings=$6,000,000 Net Income increases by $700,000 less tax @ 34%=$462,000 Less Dividend paid = 60% of net income=($3,300,000+$462,000)*60%               '=$2,257,200 Total Retained earnings calcualted as under: Earlier Retained earnings $6,000,000 Increased net income after tax $462,000 Less: dividend paid ($2,257,200) Retained Earnings $4,204,800 Total shareholders equity=($600,000+$1000,000+$4,204,800)=$11,204,800 The retun on equity after issue of common stock for acquisition=Net Income/Shareholders Equity      '=$3,762,000/$11,204,800      '=33.57% 2. If Enrietto sells additional stock then cash outflow for dividends would be as under: Net income before selling additional stock $3,300,000 The increased net income afte tax would be ($700,000*(1-0.34)) $462,000 Total net income afte tax $3,762,000 Dividend @ 60% $    2,257,200 The dividend cash outflow would be $2,257,200 3.If Enrietto sells bonds then the cash outflow for interest and dividend would be as under: Net Income before issue of bond $3,300,000 Increased net income $700,000 Less: Interest on bonds ($120,000) Net income before tax $3,880,000 Tax on income @ 34% $ (1,319,200) Income after tax $    2,560,800 Less: Dividends @ 60% $ (1,536,480) Income after dividends $    1,024,320 Total cash outflow if bonds are issued: Cash outflow for new interest $120,000 Cash outflow for dividends $    1,536,480 total cash outflow if bonds are issued $1,656,480 4. If the common stock of 50,000 shares has been sold to outsiders then the dividend paid to preacquistion shareholders after acquisition would be as under: Net Income before issue of common stock $3,300,000 Increased net income (after tax @34%) $462,000 Income after tax $    3,762,000 Less: Dividends @ 60% $ (2,257,200) Income after dividends $    1,504,800 The dividends paid to preacquistion shareholders would be : [$2,257,200/(600,000+50,000)]*600,000= $2,083,569 The dividend paid to 600,000 preacquisition shareholders= $2,083,569 5. The net income after issue of common stock is $1,504,800. The net income after issue of bonds=$1,024,320 The return on equity after issue of common stock= 33.57% The return on equity after issue of bonds= 31.02% The net income and return on equity after issue of common stock is higher than the net income and return on equity after issue of bonds therefore the company should issue common stock.

Related Questions

Navigate

• Browse (All)
• Browse E
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.