Question

Dickinson Company has $11,880,000 million in assets. Currently half of these assets are financed with long-term debt at 9.4 percent and half with common stock having a par value of $8. Ms. Smith, Vice-President of Finance, wishes to analyze two refinancing plans, one with more debt (D) and one with more equity (E). The company earns a return on assets before interest and taxes of 9.4 percent. The tax rate is 40 percent. Tax loss carryover provisions apply, so negative tax amounts are permissable.
Under Plan D, a $2,970,000 million long-term bond would be sold at an interest rate of 11.4 percent and 371,250 shares of stock would be purchased in the market at $8 per share and retired.
Under Plan E, 371,250 shares of stock would be sold at $8 per share and the $2,970,000 in proceedswould be used to reduce long-term debt.
a. How would each of these plans affect earnings per share? Consider the current plan and the two new plans. (Round your answers to 2 decimal places.)
Current Plan Plan D Plan E
Earnings per share $ $ $
b-1. Compute the earnings per share if return on assets fell to 4.70 percent. (Leave no cells blank - be certain to enter "0" wherever required. Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places.)
Current Plan Plan D Plan E
Earnings per share $ $ $
b-2. Which plan would be most favorable if return on assets fell to 4.70 percent? Consider the current plan and the two new plans.
Current Plan
Plan E
Plan D
b-3. Compute the earnings per share if return on assets increased to 14.4 percent. (Round your answers to 2 decimal places.)
Current Plan Plan D Plan E
Earnings per share $ $ $
b-4. Which plan would be most favorable if return on assets increased to 14.4 percent? Consider the current plan and the two new plans.
Current Plan
Plan E
Plan D
c-1. If the market price for common stock rose to $12 before the restructuring, compute the earnings per share. Continue to assume that $2,970,000 million in debt will be used to retire stock in Plan D and $2,970,000 million of new equity will be sold to retire debt in Plan E. Also assume that return on assets is 9.4 percent. (Round your answers to 2 decimal places.)
Current Plan Plan D Plan E
Earnings per share $ $ $
c-2. If the market price for common stock rose to $12 before the restructuring, which plan would then be most attractive?
Current Plan
Plan D
Plan E

Answer 1

Answer:

Dickinson Company

a) Effect of each plan on earnings per share:

                                 Current Plan      Plan D          Plan E

Earnings per share        $0.45            $0.36           $0.45

b-1) Earnings per share  $0                $0                 $0.14

b-2. Plan E would be most favorable if return on assets fell to 4.70%.

b-3 Earnings per share      $0.93            $0.70           $0.76

b-4 Current Plan would be most favorable if return on assets increased to 14.4%.

c-1 Earnings per share      $0.45            $0.36           $0.45

c-2 If the market price for common stock rose to $12 before the restructuring, Plan E would then be most attractive to the company as it would get additional paid-in capital of $1,485,000 ($4 * 371,250).

Explanation:

a) Data and Calculations:

Return on assets before interest and taxes = 9.4%

Tax rate = 40%

                                 Current Plan          Plan D            Plan E

Assets                       $11,880,000   $11,880,000   $11,800,000

Long-term debt          5,940,000      5,940,000     2,970,000

New debt                                           2,970,000

Total debt                                          8,910,000

Common stock          5,940,000     5,940,000      8,910,000

Less repurchased shares               (2,970,000)

New common stock                        2,970,000

Interest rate of old debt   9.4%            9.4%               9.4%

Interest rate for new debt                   11.4%

Stock par value              $8                 $8                 $8

Return on assets before

interest and taxes     $1,116,720    $1,116,720       $1,116,720

Interest expense          558,360       896,940          298,180

Return before taxes  $558,360      $219,780       $837,540

Tax rate = 40%             223,344          87,912          335,016

Return after taxes      $335,016      $131,868       $502,524

Shares outstanding    742,500       371,250         1,113,750

Earnings per share      $0.45            $0.36           $0.45

Return on assets falling to 4.70%

Return on assets before

interest and taxes     $558,360     $558,360      $558,360

Interest expense          558,360       896,940         298,180

Return before taxes     $0             -$338,580       $260,180

Tax rate = 40%                0                   0                   104,072

Return after taxes       $0                $0                   $156,108

Shares outstanding     742,500       371,250         1,113,750

Earnings per share          $0                $0                 $0.14

Return on assets increasing to 14.4%:

Return on assets before

interest and taxes    $1,710,720    $1,710,720      $1,710,720

Interest expense          558,360       896,940          298,180

Return before taxes $1,152,360      $431,380     $1,412,540

Tax rate = 40%             460,944        172,552         565,016

Return after taxes       $691,416    $258,828       $847,524

Shares outstanding     742,500       371,250         1,113,750

Earnings per share      $0.93            $0.70           $0.76

Market price for common stock rose to $12 before restructuring:

Return on assets before

interest and taxes     $1,116,720    $1,116,720       $1,116,720

Interest expense          558,360       896,940          298,180

Return before taxes  $558,360      $219,780       $837,540

Tax rate = 40%             223,344          87,912           335,016

Return after taxes      $335,016      $131,868       $502,524

Shares outstanding     742,500       371,250         1,113,750

Earnings per share       $0.45            $0.36           $0.45