(The effects of leverage, LO 4) 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 is close to the stage when extraction will occur. 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 that it believes it has discovered.

Chitek’s CEO is considering two options: selling additional shares in the company or borrowing the required funds. If the company borrows, it will have to pay 12%

interest per year. If it uses equity, it will have to sell 2,000,000 shares to raise the required amount of money.

Oil and gas exploration is a risky business. The performance of an oil and gas exploration company is subject to many factors, including the quantity of oil and gas that can be economically extracted from a particular location, the market price of the resource, and the ability of the entity to control its 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 considering 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.

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 it 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 obtain the additional

$8,000,000? Explain.