Chitek Inc. (Chitek) is an oil and gas exploration company operating in northern Canada. Chitek has not yet begun extracting oil or gas from the ground, but it’s close to that stage. When Chitek was formed about 18 months ago, shareholders contributed \($12,000,000\) in exchange for 6,000,000 common shares in the company. Chitek now requires \($8,000,000\) of additional capital to exploit the resources it believes it has discovered.

Chitek’s CEO is considering two options: sell additional shares in the company or borrow the required funds. If the company borrows, it will have to pay 9 percent interest per year. If it uses equity, it will have to sell 2,000,000 shares to raise the money.

Oil and gas exploration is a risky business. Performance is subject to many factors, including the quantity of oil and gas that can be economically extracted, the market price of the resource, and the ability to control costs. Chitek’s CEO has projected two possible outcomes: a good outcome and a poor outcome. Under the good outcome, the CEO estimates that income from operations (income before financing costs)

will be \($2,000,000\) in the first year. Under the poor outcome, the CEO estimates that income from operations will be \($500,000\) in the first year.

Assume Chitek has a tax rate of 16 percent, and all tax effects are reflected in operating income except for the tax effect of the additional debt or equity.

Required:

a. Prepare partial income statements for Chitek assuming:

i. Equity financing of the additional \($8,000,000\) and the good outcome.

ii. Equity financing of the additional \($8,000,000\) and the poor outcome.

iii. Debt financing of the additional \($8,000,000\) and the good outcome.

iv. Debt financing of the additional \($8,000,000\) and the poor outcome.

b. Calculate basic earnings per share and return on shareholders’ equity for the four scenarios described in (a).

c. Explain the advantages and disadvantages of Chitek using debt and the advantages and disadvantages of using equity.

d. If you were a prospective lender, would you lend \($8,000,000\) to Chitek? Explain.

e. Would you advise Chitek to use debt or equity to raise the additional $8,000,000?
Explain.