Question

Crane Company is considering these two alternatives for financing the purchase of a fleet of airplanes:

Issue 62,500 shares of common stock at $45 per share. (Cash dividends have not been paid nor is the payment of any contemplated.)
Issue 13%, 15-year bonds at face value for $2,812,500. It is estimated that the company will earn $824,000 before interest and taxes as a result of this purchase.
The company has an estimated tax rate of 40% and has 93,600 shares of common stock outstanding prior to the new financing.

Determine the effect on net income and earnings per share for issuing stock and issuing bonds. Assume the new shares or new bonds will be outstanding for the entire year.

Answer 1

Answer:

(1) $494,400; $3.16

(2) $275,025; $2.93

Explanation:

Plan One Issue Stock:

Interest = $0

Income before taxes = $824,000

Income tax expense = 40% of $824,000

                                  = $329,600

Net income = Income before taxes - Income tax expense

                    =  $824,000 - $329,600

                    = $494,400

Earnings per share = Net income ÷ Outstanding shares

                                = $494,400 ÷ 156,100

                                = $3.16

Plan two Issue Bonds:

Interest = 13% of $2,812,500

             = $365,625

Income before interest and taxes = $824,000

Income before taxes = Income before interest and taxes - Interest

                                   = $824,000 - $365,625

                                   = $458,375

Income tax expense = 40% of $458,375

                                  = $183,350

Net income = Income before taxes - Income tax expense

                    =  $458,375 - $183,350

                    = $275,025

Earnings per share = Net income ÷ Outstanding shares

                                = $275,025 ÷ 93,600

                                = $2.93