Campbell, Inc has net income of $500,000 and 200,000 shares of common stock

Question

The company is considering a project that requires $800,000 and is considering two options:
• Option 1 is to borrow $800,000 at 12%.
• Option 2 is to issue 100,000 shares of common stock for $800,000.

Considering all relevant facts and figures, Campbell's management is of the opinion that the funds raised can be used to increase income before interest and taxes by $300,000 each year. The company estimates income tax expense to be 40%. Analyze the Campbell situation to determine which plan will result in higher earnings per share. (Round your answers to two decimal points.)
What will be an ideal response

Answer 1

Option 1 Option 2
Net income before new project $ 500,000 $ 500,000
Expected income on the new project
before interest and income tax
expenses $ 300,000 $ 300,000
Less: Interest Expense
($800,000 x 12%) 96,000 0
Project income before income tax 204,000 300,000
Less: Income tax expense 81,600 120,000
Project net income 122,400 180,000
Net income with new project $622,400 $680,000
Earnings per share with new project
Option 1 ($622,400 / 200,000 ) 3.11
Option 2 ($680,000 / 300,000 ) 2.27

Because the EPS of option 1 is more than option 2, Campbell, Inc. should borrow the amount to fund the investment.