Leverage} Enrietto Aquatic Products Ltd.'s offer to acquire Fibreglass Products for ($ 2,000,000) cash has been accepted.

Question:

Leverage}

Enrietto Aquatic Products Ltd.'s offer to acquire Fibreglass Products for $\$ 2,000,000$ cash has been accepted. Enrietto has $\$ 1,000,000$ of liquid assets that can be converted into cash and plans to either sell common shares or issue bonds to raise the remaining $\$ 1,000,000$. Before this acquisition, Enrietto's condensed statement of financial position and condensed statement of earnings were as follows:

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Enrietto's policy is to pay $60 \%$ of net income to shareholders as dividends. Enrietto expects to be able to raise the $\$ 1,000,000$ it needs for the acquisition by selling 50,000 common shares at $\$ 20$ each or by issuing $\$ 1,000,000$ of 20 -year, $12 \%$ bonds. Enrietto expects income from operations to grow by $\$ 700,000$ after Fibreglass Products has been acquired. (Interest expense will increase if debt is used to finance the acquisition.)
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1. Determine the return on equity (net income/total equity) before the acquisition and for both financing alternatives.
2. If Enrietto sells additional shares, what will be the cash outflow for dividends?
3. If Enrietto sells bonds, what will be the net cash outflows for new interest and for all dividends? (Remember that interest is tax-deductible.)
4. Assume that Enrietto sells shares and that none of the preacquisition shareholders buy any of the 50,000 new shares. What total amount of dividends will the preacquisition shareholders receive after the acquisition? How does this amount compare with the dividends they receive before the acquisition?
5. Based only on Return on Equity, which alternative is better for Enrietto's preacquisition shareholders?
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