LEVERAGE Enrietto Aquatic Products’ offer to acquire Fiberglass 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 stock or issue bonds to raise the remaining

$1,000,000. Before this acquisition, Enrietto’s condensed balance sheet and condensed income statement were as follows:

ENRIETTO AQUATIC PRODUCTS Preacquisition Condensed Balance Sheet Assets Liabilities and Equity Assets $20,000,000 Liabilities $ 8,000,000 Common stock, $10 par 6,000,000 Retained earnings 6,000,000 Total liabilities & stockholders’ equity $20,000,000 ENRIETTO AQUATIC PRODUCTS Preacquisition Condensed Income Statement Income from operations $6,000,000 Less: Interest expense l,000,000 Income before taxes $5,000,000 Less: Income taxes expense (0.34) 1,700,000 Net income $3,300,000 Enrietto’s policy is to pay 60 percent of net income to stockholders as dividends.

Enrietto expects to be able to raise the $1,000,000 it needs for the acquisition by selling 50,000 shares of common stock at $20 each or by issuing $1,000,000 of 20-

year, 12 percent bonds. Enrietto expects income from operations to grow by

$700,000 after Fiberglass Products has been acquired. (Interest expense will increase if debt is used to finance the acquisition.)

Required:

. Determine the return on equity (net income/total equity) before the acquisition and for both financing alternatives.

. If Enrietto sells additional stock, what will be the cash outflow for dividends?

. If Enrietto sells bonds, what will be the net cash outflows for new interest and for all dividends? (Remember that interest is tax-deductible.)

. Assume that Enrietto sells stock and that none of the preacquisition stockholders buy any of the 50,000 new shares. What total amount of dividends will the preacquisition stockholders receive after the acquisition? How does this amount compare with the dividends they receive before the acquisition?

. Which alternative is better for Enrietto’s preacquisition stockholders?

Case