A firm needs $5 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 $65 per share. To sell this new issue, the stock would have to be underpriced by $2 and sold for $63 per share. The firm currently has 600,000 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 $73 per share, and the bond could be sold at par. The earnings for the firm are expected to be $4,000,000 in the coming year. Assuming the firm chooses the convertible bond, the earnings per share after all bonds are converted will be ________.

Question

Quizplus · Accepted Answer

To raise $5 million:
- If the firm chooses to issue common stock, it will have to issue (5,000,000/63) = 79,365 shares, which would increase the total shares outstanding to 679,365 shares. 
- If the firm chooses to issue convertible bonds, it will have to issue (5,000,000/1,000) = 5,000 bonds.

If the firm issues common stock:
- Earnings per share (EPS) = Total Earnings / Total Shares Outstanding 
- EPS = 4,000,000 / 679,365 = $5.89

If the firm issues convertible bonds:
- The conversion price is $73 per share, so each bond can be converted into 1,000/73 = 13.70 shares of common stock.
- Total shares outstanding after conversion = 600,000 + 5,000 x 13.70 = 673,500 shares.
- EPS = 4,000,000 / 673,500 = $5.98

Therefore, the best choice for the firm is to issue convertible bonds because it would result in a higher EPS after all bonds are converted.

A Firm Needs $5 Million of New Long-Term Financing