Question

Baja Airlines is considering these two alternatives for financing the purchase of a fleet of airplanes. 1. Issue 50,000 shares of common stock at $40 per share. (Cash dividends have not been paid nor is the payment of any contemplated.) 2. Issue 12%, 10-year bonds at face value for $2,000,000. It is estimated that the company will earn $800,000 before interest and taxes as a result of this purchase. The company has an estimated tax rate of 30% and has 90,000 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. (Round earnings per share to 2 decimal places, e.g. $2.66.)

Answer 1

Answer:

Baja Airlines

Financing Alternatives:

                                                  Issued Common Stock   Issued 12% Bonds

Earnings before interest & taxes         $800,000                  $800,000

Interest                                                                                        240,000

Earnings before taxes                          $800,000                  $560,000

Taxes: 30%                                              240,000                     168,000

Net Income                                           $560,000                  $392,000

Number of Shares Issued                       140,000                      90,000

EPS                                                          $4                             $4.36

Explanation:

a) With the issue of new shares, the net income was $560,000 unlike when bonds were issued, and the net income was $392,000.  This shows that bond interest reduced the after-tax net income by $168,000.

b) EPS is earnings per share.  It is the net income divided by the number of outstanding shares.  With the issue of new shares, the EPS was $4 unlike when bonds were issued, and the EPS recorded was $4.36.

c) Implication: Stockholders benefit more with the issue of bonds than with the issue of new shares which dilute their earnings.