East-West Airlines is considering two alternatives to finance the purchase of a fleet of airplanes. These alternatives are (1) to issue 120,000 common shares at $45 per share, and (2) to issue 10-year, 5% bonds for $5.4 million. It is estimated that the company will earn an additional $1.2 million before interest and income tax as a result of this purchase. The company has an income tax rate of 30%. It has 200,000 common shares issued and average shareholders' equity of $12 million before the new financing.
Instructions
(a) Calculate the profit for each financing alternative.
(b) Calculate the earnings per share and return on equity for each alternative.
(c) Which financing alternative would you recommend for East-West Airlines? Why?