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Zohan Health is considering two alternatives for the financing of some high technology medical equipment. These two alternatives are: Issue 60,000 shares of $10 par value common stock at $50 per share.Issue $3,000,000, 8%, 10-year bonds at par. It is estimated that the company will earn $900,000 before interest and taxes as a result of acquiring the medical equipment. The company has an estimated tax rate of 40% and has 80,000 shares of common stock outstanding prior to the new financing. InstructionsDetermine the effect on net income and earnings per share for these two methods of financing. Use the table presented last session to compare Equity and Debt financing.

Question

Zohan Health is considering two alternatives for the financing of some high technology medical equipment. These two alternatives are: Issue 60,000 shares of 10parvaluecommonstockat10 par value common stock at 50 per share.Issue 3,000,000,83,000,000, 8%, 10-year bonds at par. It is estimated that the company will earn 900,000 before interest and taxes as a result of acquiring the medical equipment. The company has an estimated tax rate of 40% and has 80,000 shares of common stock outstanding prior to the new financing. InstructionsDetermine the effect on net income and earnings per share for these two methods of financing. Use the table presented last session to compare Equity and Debt financing.

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Solution

Sure, let's break down the two financing alternatives and calculate the effect on net income and earnings per share (EPS).

  1. Issuing 60,000 shares of common stock:

    If Zohan Health issues 60,000 shares at 50pershare,theywillraise50 per share, they will raise 3,000,000. This method of financing does not involve any interest expense.

    The earnings before interest and taxes (EBIT) is 900,000.Sincethereisnointerestexpense,theearningsbeforetaxes(EBT)isalso900,000. Since there is no interest expense, the earnings before taxes (EBT) is also 900,000.

    The company's tax rate is 40%, so the taxes would be 40% of 900,000,whichis900,000, which is 360,000.

    Therefore, the net income would be 900,000−900,000 - 360,000 = $540,000.

    The number of shares outstanding after the new financing would be 80,000 (existing shares) + 60,000 (new shares) = 140,000 shares.

    Therefore, the EPS would be 540,000/140,000=540,000 / 140,000 = 3.86 per share.

  2. Issuing $3,000,000, 8%, 10-year bonds:

    If Zohan Health issues 3,000,000of83,000,000 of 8% bonds, they will have to pay annual interest of 8% of 3,000,000, which is $240,000.

    The EBIT is 900,000.Aftersubtractingtheinterestexpense,theEBTis900,000. After subtracting the interest expense, the EBT is 900,000 - 240,000=240,000 = 660,000.

    The taxes would be 40% of 660,000,whichis660,000, which is 264,000.

    Therefore, the net income would be 660,000−660,000 - 264,000 = $396,000.

    Since no new shares are issued, the number of shares outstanding remains 80,000.

    Therefore, the EPS would be 396,000/80,000=396,000 / 80,000 = 4.95 per share.

In conclusion, issuing bonds results in a lower net income due to the interest expense, but a higher EPS due to the smaller number of shares outstanding. On the other hand, issuing shares results in a higher net income but a lower EPS due to the larger number of shares outstanding.

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