United Holdings Inc. requires $ 5,000,000 in new financing in order to expand its operations. The management team is in discussion about the best way to finance the expansion and has asked you, their accountant, for assistance. In order to provide them with the information they need, you analyze the following two options:
1. Issue 1,000,000 common shares at $ 5, which is the current market price of United's 2,000,000 issued common shares.
2. Issue $ 5,000,000 of 10-year, 4% bonds at par. United currently has no bonds payable issued.
The financing would be required at the beginning of the next fiscal year. United's tax rate is 30%. The management team projects profit of $ 1,750,000 before financing costs and taxes. They are interested in comparing the net income after tax, the earnings per share, and the return on equity under each alternative. The management team's goal is to maximize return on equity in the first year. United's shareholders' equity is currently $ 17,500,000.
Instructions
Calculate the amounts requested by the management team and present the two alternatives in comparative format. Recommend which alternative should be chosen.

Question

Quizplus · Accepted Answer

The Answer of United Holdings Inc. requires $ 5,000,000 in new financing in order to expand its operations. The management team is in discussion about the best way to finance the expansion and has asked you, their accountant, for assistance. In order to provide them with the information they need, you analyze the following two options:
1. Issue 1,000,000 common shares at $ 5, which is the current market price of United's 2,000,000 issued common shares.
2. Issue $ 5,000,000 of 10-year, 4% bonds at par. United currently has no bonds payable issued.
The financing would be required at the beginning of the next fiscal year. United's tax rate is 30%. The management team projects profit of $ 1,750,000 before financing costs and taxes. They are interested in comparing the net income after tax, the earnings per share, and the return on equity under each alternative. The management team's goal is to maximize return on equity in the first year. United's shareholders' equity is currently $ 17,500,000.
Instructions
Calculate the amounts requested by the management team and present the two alternatives in comparative format. Recommend which alternative should be chosen.