(The effects of leverage, LO 4) Greenway Television (Greenway) owns licenses to -

operate eight new digital specialty television channels. Greenway was recently granted the licenses by the CRTC and plans to begin broadcasting within six to eight months. Greenway already has agreements in principle with cable and satellite operators to include Greenway’s channels on their systems (although these agreements are not binding).

When Greenway was organized two years ago with the purpose of developing specialty channels, the company raised $5,000,000 by selling 2,000,000 common shares to investors. Now that Greenway has received its licenses from the CRTC, it is in need of an additional $5,000,000 to prepare the channels for going on air.

Greenway’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 10% interest per year. If it uses equity, it will have to sell 1,000,000 shares to raise the required amount of money.

The success of Greenway has two main elements—subscribers and advertising revenues. The more subscribers it has and the more money advertisers are prepared to spend to buy advertising time on a channel, the more financially successful Greenway will be. Once the channels are operating, Greenway will receive a fixed fee for each person who subscribes to a channel. Cable and satellite operators sometimes bundle channels, so if a channel is bundled with other channels that are very attractive to viewers, the channel in question will generate revenues regardless of whether many people watch it.

Greenway’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 $1,500,000 in the first year. Under the poor outcome, the CEO estimates that income from operations will be $300,000 in the first year.
Required:

a. Prepare partial income statements for Greenway assuming:
i. Equity financing of the additional $5,000,000 and the good outcome.
i. Equity financing of the additional $5,000,000 and the poor outcome.
ii. Debt financing of the additional $5,000,000 and the good outcome.
iv. Debt financing of the additional $5,000,000 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 Greenway using debt, and the advantages and disadvantages of it using equity.

d. If you were a prospective lender, would you lend $5,000,000 to Greenway?
Explain.

e. Would you advise Greenway to use debt or equity to obtain the additional $5,000,000? Explain.