Fanny Nanny Weight Monitors Inc. is considering two financial alternatives for financing a major expansion program. Under either alternative, EBIT is expected to be $12.5million. Currently the firm's capital structure consists of 2 million shares of common stock and $15 million in 6% long-term bonds. Under the debt financing alternative $8 million in 4% long-term bonds will be sold and under the equity financing alternative the firm would sell 150,000 shares of common stock. The P/E under the debt alternative would be 21 and the P/E under the equity alternative would be 22. The firm's marginal tax rate is 40%. Which alternative would produce the higher stock price?
A) debt-stock price of $57.36
B) debt-stock price of $70.98
C) equity-stock price of $71.28
D) equity-stock price of $85.32

Question

Quizplus · Accepted Answer

To determine which financing option results in a higher stock price, we need to calculate the earnings per share (EPS) under each alternative and then apply the respective P/E ratios.**Debt Financing:**- EBIT: $12.5 million- Interest on new debt: $8 million * 4% = $0.32 million- Total interest (existing + new): $0.9 million (existing $15 million * 6%) + $0.32 million = $1.22 million- Earnings before tax (EBT): $12.5 million - $1.22 million = $11.28 million- Taxes (40%): $11.28 million * 40% = $4.512 million- Net income: $11.28 million - $4.512 million = $6.768 million- Shares outstanding: 2 million (no new equity issued)- EPS (Debt): $6.768 million / 2 million shares = $3.384- Stock price (Debt): $3.384 * 21 (P/E ratio) = $71.064**Equity Financing:**- EBIT: $12.5 million- Interest (no change in debt): $0.9 million- Earnings before tax (EBT): $12.5 million - $0.9 million = $11.6 million- Taxes (40%): $11.6 million * 40% = $4.64 million- Net income: $11.6 million - $4.64 million = $6.96 million- Shares outstanding: 2 million + 0.15 million (new equity issued) = 2.15 million- EPS (Equity): $6.96 million / 2.15 million shares = $3.237- Stock price (Equity): $3.237 * 22 (P/E ratio) = $71.214The equity financing alternative produces a slightly higher stock price, making option C the correct choice.