Question

Olivia Hardison, CFO of Impact United Athletic Designs, plans to have the company issue $500 million of new common stock and use the proceeds to pay off some of its outstanding bonds. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following would occur?
The company's taxable income would fall.
The company would have less common equity than before.
The company's net income would increase.
The company would have to pay less taxes.
The company's interest expense would remain constant.Olivia Hardison, CFO of Impact United Athletic Designs, plans to have the company issue $500 million of new common stock and use the proceeds to pay off some of its outstanding bonds. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following would occur?
The company's taxable income would fall.
The company would have less common equity than before.
The company's net income would increase.
The company would have to pay less taxes.
The company's interest expense would remain constant.

Answer 1

Answer:

The company's net income would increase.

Explanation:

The company issued $500 million of common stock and paid off bonds (debt). Then the questions asks what would occur given some assumptions.

1. The company's taxable income would fall - This is false; issuing stock doesn't have an impact on earnings and by paying off debt, the company reduces interest to be paid, therefore increasing taxable income.

2. The company would have less common equity than before -  This is false; issuing stock increases the common equity of the company, and as dividends are not paid, there is no reduction of common equity.

3. The company's net income would increase - This is true; by paying off debt, the company reduces interests to be paid, thus increasing net income.

4. The company would have to pay less taxes - This is false; as less interests are paid, the EBT (Earnings Before Taxes) increase, and as the tax rate remains constant, the company will end up paying more taxes.

5. The company's interest expense would remain constant - This is false; by applying the proceeds to pay off the bonds, the interest expenses paid by the company would be lower.