(Analyzing the effects of different financing alternatives, LO 2,6) Owakonze Inc.

(Owakonze) is in need of $1,000,000 to finance an expansion of its operations.

Management is considering three financing alternatives:

i. Issue 100,000 common shares to a group of private investors for $10 per share.

In recent years dividends of $0.40 per share have been paid on the common shares.

ii. Issue 40,000 cumulative preferred shares with an annual dividend of $2 per share. The preferred shares are redeemable after 10 years for $27 per share.

iii. Issue a $1,000,000 bond with a coupon rate of 11% per year and maturity in 15 years.

It is now late July 2006. Owakonze’s year end is July 31. Owakonze plans to raise the needed money at the beginning of its 2007 fiscal year, but management wants to know the financial statement effects and implications of each of the alternatives.

Owakonze’s accounting department has provided a projection of the right-hand side of the balance sheet as of July 31, 2007 and a summarized projected income statement for the year ended July 31, 2007. The projected statements do not reflect any of the proposed financing alternatives. If the current expansion plan is successful, Owakonze anticipates the need to raise additional money in the near future. One of Owakonze’s loans has a covenant that requires the debt-to-equity ratio be below 1.1. Owakonze has a tax rate of 30%.

Required:a. Calculate net income for Owakonze under the three financing alternatives.

b. Calculate basic earnings per share and return on shareholders’ equity.

c. Prepare a report to Owakonze’s management explaining the effect of each of the financing alternatives on the financial statements. Include in your report a discussion of the pros and cons of each financing alternative. Also, make a recommendation as to which alternative it should choose. Support your recommendation.

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Owakonze Ltd. Summarized Projected Income Statement as of July 31, 2007 Revenue Expenses Income tax expense Net income Owakonze Ltd. $1,900,000 1,400,000 150,000 $ 350,000 Summarized Projected Liabilities and Shareholders' Equity as of July 31, 2007 Liabilities Shareholders' equity: Preferred stock (200,000 shares authorized, 0 issued) Common stock (unlimited number of shares authorized, 200,000 outstanding) Retained earnings Total liabilities and shareholders' equity $ 750,000 950,000 800,000 $2,500,000