You are working as an intern for a small CPA firm. A new client has approached the firm about starting a new company called Cherokee Plastics. The specific question is should I use equity or debt financing to raise money for the new business?

Your boss has assigned you to prepare a report that will answer this question for the client. A common problem facing any business entity is the debt versus equity decision What will be the mix of debt versus equity in the initial capital structure? The characteristics of debt are very different from those of equity as are the financial implications of using one method of financing as opposed to the other. As you begin to ponder the question, you are provided with the below information:

Cherokee Plastics Corporation is to be formed by a group of investors to manufacture household plastic products. Their initial capitalization goal is $50,000,000. That is, the incorporators have decided to raise $50,000,000 to acquire the initial assets of the company. They have narrowed down the financing mix alternatives to two:

1. All equity financing.
2. $20,000,000 in debt financing and $30,000,000 in equity financing No matter which financing alternative is chosen, the corporation expects to be able to generate a 10% annual return, before payment of interest and income taxes, on the $50,000,000 in assets acquired.

The interest rate on debt would be 8%. The effective income tax rate will be approximately 25%. Alternative 2 will require specified interest and principal payments to be made to the creditors at specific dates. The interest portion of these payments (interest expense) will reduce the taxable income of the corporation and hence the amount of income tax the corporation will pay. The all-equity alternative requires no specified payments to be made to suppliers of capital. The corporation is not legally liable to make distributions to its owners. If the board of directors does decide to make a distribution, it is not an expense of the corporation and does not reduce taxable income and hence the taxes the corporation pays. Required:

1. Construct an income statement for the first year of operations assuming Cherokee uses all equity financing, alternative 1 above.
2. Construct an income statement for the first year of operations assuming Cherokee uses a combination of debt/equity financing, alternative 2 above.
3. Which alternative would be expected to achieve the highest first-year profits?
4. Which alternative would provide the highest rate of return on equity?
5. Which alternative is riskier, all else equal?