A company is assessing two alternatives for new debt financing that have been suggested by an underwriting firm. An issue of $5 million is needed to support projected capital outlays for the coming year. The company already has $1,500,000 of 10% straight debt outstanding as well as 100,000 common shares with a total book value of $2 million. Two alternatives for the new debt issue have been suggested:

1.A $3 million, 10-year, 10% convertible debenture with a $40 conversion price and $1,000 par value.

2.A $3 million, 10-year, 11% straight bond issue. Each $1,000 bond has a detachable warrant to purchase 10 shares for $40 per share.

The issuing company has projected EBIT of $1,250,000 and a 40% tax rate.

REQUIRED:

Using the attached table, analyze the two financing opportunities presented by the underwriting firm.

a)Show how the current capitalization of the company would be immediately affected by each proposed debt issue.

b)Also calculate the projected earnings per share for the coming year, assuming that no conversion or exercise of warrants occur.

c)Show the effect on the capitalization of the company and on earnings per share if:

i)conversion occurs immediately for the convertible debt alternative

ii)warrants are exercised immediately for the bond plus warrants package.

d)Discuss the advantages and disadvantages of the two proposed debt issues, and make recommendations to the issuing company.