Use of Leverage Solid Corporation has operated for 30 years and has done so with very little debt. The last bond issue was retired in 1996, 5 years ahead of schedule.

The company needs to expand and is planning to issue 10,000 additional shares of common stock at $25 per share.

Another option would be to issue $250,000 of 20-year, 10 percent bonds.

Solid Corporation reported net income for the current year of $70,000 and currently has 40,000 shares of common stock outstanding. The company estimates that by investing in additional equipment and replacing some existing equipment, income before interest and taxes can be increased by

$50,000 per year. The company’s effective income tax rate is 40 percent.

a. What would be the expected increase in net income under each of the two financing alternatives?

b. What amount would be reported as earnings per share before the purchase of new equipment? What would be the estimated earnings per share under each of the financing alternatives? Should Solid Corporation purchase the equipment? If so, which financing alternative should be used? Explain.

c. Would your answer be the same if expected earnings before interest and tax increased by $20,000, rather than

$50,000? Explain.