A corporation plans to invest $1 million in oil exploration. The corporation is considering two plans to raise the money. Under Plan #1, bonds with a contract rate of interest of 6% would be issued. Under Plan #2, 50,000 additional shares of common stock would be issued at $20 per share. The corporation currently has 300,000 shares of stock outstanding, and it expects to earn $700,000 per year before bond interest and income taxes. The net income and return on investment for both plans is shown below:?Plan #1? Plan #2Earnings before bond interest and taxes……..$ 700,000 ?$ 700,000Bond interest expense………………………(60,000)??Income before taxes………………………..$ 640,000 ?$ 700,000 Income

Question

taxes……………………………….(224,000)?(245,000)Net income…………………………………$ 416,000 ?$ 455,000 ????Equity………………………………………$8,000,000 ?$9,000,000 Return on Equity……………………………5.2%?5.06%Comment on the relative effects of each alternative, including when one form of financing is preferred to another.

What will be an ideal response?

Answer 1

Plan #1 provides a slightly higher return on equity, but it creates additional risk. If the corporation has a bad year and does not earn sufficient net income, it will still be obligated to pay out the $60,000 interest cost under Plan #1. On the other hand, Plan #2 does not require any periodic cash outflows. However, Plan #2 does dilute ownership through the issuance of additional shares. In summary, if the issuer expects to earn high returns with the funds, then bond financing is preferred. If the issuer expects marginal and/or risky returns, then stock financing is preferred.