A firm needs $2 million of new long-term financing. The firm is considering the sale of common stock or a convertible bond. The current market price of the common stock is $42 per share. To sell this new issue, the stock would have to be underpriced by $2 and sold for $40 per share. The firm currently has 300,000 shares of common stock outstanding. The alternative is to issue 20-year, 10 percent, and $1,000 par-value convertible bonds. The conversion price would be set at $50 per share, and the bond could be sold at par. The earnings for the firm are expected to be $500,000 in the coming year. Assuming the firm chooses the sale of common stock, the earnings per share in the coming year will be ________.

Question

Quizplus · Accepted Answer

To calculate the earnings per share (EPS) in the coming year, we need to divide the expected earnings ($500,000) by the number of outstanding shares after the new issue.

If the firm sells the new issue of common stock, it will issue $2,000,000 / $40 = 50,000 new shares. Therefore, the total number of outstanding shares will be 300,000 + 50,000 = 350,000.

EPS = $500,000 / 350,000 = $1.43.

Now, let's consider the alternative of issuing convertible bonds. The conversion price is $50 per share, meaning that each bond can be converted into 20 shares of common stock ($1,000 par-value bond / $50 conversion price). If the firm issues $2,000,000 worth of convertible bonds, it will issue 2,000 convertible bonds ($2,000,000 par value / $1,000 per bond), which can be converted into 40,000 new shares of common stock (2,000 bonds * 20 shares per bond).

Therefore, the total number of outstanding shares after conversion will be 300,000 + 40,000 = 340,000.

If the firm chooses to issue convertible bonds and all the bonds are converted, the EPS in the coming year will be:

EPS = $500,000 / 340,000 = $1.47.

Comparing the EPS of the two options, we can see that issuing common stock will result in a lower EPS ($1.43 vs. $1.47). However, we also need to consider the dilution effect of issuing additional shares. By issuing common stock, the ownership of the existing shareholders will be diluted, whereas issuing convertible bonds will not result in immediate dilution (only if the bondholders convert their bonds into shares).

Therefore, the best choice depends on the firm's objectives and the preferences of its management and shareholders. If the firm wants to avoid dilution, it may prefer to issue convertible bonds. If the firm values higher EPS and is willing to accept dilution, it may prefer to issue common stock.

A Firm Needs $2 Million of New Long-Term Financing