Problem B: Capital Structure and Leverage.

Atlas Company is a closely held corporation with a capital structure composed entirely of common stock and retained earnings. The stockholders have an agreement with the company that states the company will purchase a shareholders stock should a shareholder want to sell his or her holdings in the company. The agreement states that the stock will be purchased at a price equal to the stocks previous year-end book value per share.

Early in October 20X1 Mrs Elizabetta, the widow of one of Atlass major shareholders, expressed an interest in selling her stock in accordance with the buy-back pricing arrangement. Mrs Elizabetta owns 600,000 shares of the 3,000,000 shares of Atlas Company common stock.

The Board of Directors has concluded that the company must replace the capital used to repurchase the shares. The board has assurances that it would be able to finance the acquisition of stock by borrowing the necessary funds on 10-year notes through a private placement at an annual interest rate of 10 per cent. Thus, the company would have capital provided by debt and perhaps be able to take advantage of financial leverage.

The board and Mrs Elizabetta agreed that the exchange will take place on January 1, 20X2. The book value per share of common stock is projected to be $50 on December 31, 20X1. The controller of Atlas Company had prepared a forecast and pro forma statements for 20X2. An excerpt of the forecasted earnings statement for the year ended December 31, 20X2 is presented below (in thousands of dollars). Atlas used a 40% income tax rate in the forecasted statement. The pro forma statements do not reflect the repurchase of Mrs Elizabettas shares or the new issue of debt required to pay for the shares.

Income before income taxes $50,000

Less income taxes (40%) 20,000

Net income 30,000

(a) Revise the excerpts from Atlas Companys forecasted earnings statement for the year ending December 31, 20X2, to reflect the long-term debt financing used to purchase Mrs Elizabettas common stock. Assume the 40 per cent tax will still be applicable.

(b) Explain the impact of long-term debt financing on Atlas Companys earnings per share and return on stockholders equity using the forecasted data for 20X2.

(c) Identify and discuss the advantages and disadvantages of financial leverage for a company with a capital structure similar to Atlas Company before and after this long-term debt has been added.