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E15–19 Knutsen Financial Services Ltd
E15–19 Knutsen Financial Services Ltd. needs to raise $3,000,000 to expand company operations. Knutsen’s president is considering two options:
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Plan A: $3,000,000 of 4 percent bonds payable to borrow the money
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Plan B: 300,000 common shares at $10.00 per share
Before any new financing, Knutsen Financial Services Ltd. expects to earn net income of $900,000, and the company already has 300,000 common shares outstanding. The president believes the expansion will increase income before interest and income tax by $600,000. The company’s income tax rate is 30 percent.
Required
Prepare an analysis similar to Exhibit 15–9 on page 842, to determine which plan is likely to result in the higher earnings per share. Which financing plan would you recommend for Knutsen Financial Services Ltd.? Give your reasons.
Expert Solution
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Plan A: $3,000,000 of 4 percent bonds payable to borrow the money
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Plan B: 300,000 common shares at $10.00 per share
Net income = $900,000,
Common shares outstanding before expansion = 300,000
Increase in income before interest and income tax after expansion = $600,000
Net income after expansion = 900,000+600,000 = $15,00,000
Tax rate = 30 percent
| Plan A | Plan B | ||
| a | Income before interest and tax | 15,00,000 | 15,00,000 |
| b | Interest (4%) | 120000 | 0 |
| (4% of 3,000,000) | |||
| c | Income before tax (a-b) | 13,80,000 | 15,00,000 |
| d | Tax (30%) (c*30%) | 414000 | 450000 |
| e | Income after tax (c-d) | 9,66,000 | 10,50,000 |
| f | Outstanding shares | 300,000 | 600,000 |
| g | EPS (e/f) | 3.22 | 1.75 |
Knutsen Financial Services Ltd. must go for plan A if their final objective is of wealth maximisation (maximum wealth for shareholders), since plan A provides an earning per share of $3.22 which is more than that provided by plan B of $1.75.
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