A company is considering issuing additional stock or taking on debt to finance some planned growth. The most recent balance sheet of the company shows the following:

Assets $10 million

Liabilities – current $ 3 million

Liabilities – long term $ 2 million

Common Stock $ 4 million

Retained Earnings $ 1 million

# shares outstanding 100,000

The company needs to raise $7 million for a planned expansion and pay off existing debt. 

The options under consideration are:

Issue 140,000 shares for $50 a share.

Finance 100% of the required cash requirements with debt. Interest rates are currently increasing. The company hopes to secure a five-year, 5% loan. Interest will be paid yearly, with the entire principal of the loan due at maturity.

Finance half the needed funds with equity and half with debt.

Other information

The company has not previously paid dividends to its shareholders as it has needed the cash to grow the company. However, shareholders are grumbling, and the company is planning to pay $0.5 per share starting this next year.

The company hopes the new revenue stream from the planned expansion will result in income before interest expense and taxes of $1,000,000 next year.

Assume the tax rate will be 20%.

Required:

Prepare an income statement for the next year for each scenario starting with “income before interest expense and taxes”. 

Compute earnings per share. (net income / number of shares outstanding)

Which scenario would you recommend and why. Do discuss items to consider in your analysis. What are the advantages of debt? Of equity?