Farar, Inc. projects operating income of $4 million next year. The firm's income tax rate is 40%. Farar presently has 750,000 shares of common stock, no preferred stock, and no debt. The firm is considering the issuance of $6 million of 10% bonds to finance a new product that is not expected to generate an increase in income for two years. If Farar issues the bonds this year, what will projected EPS be next year?
A) $1.53
B) $1.98
C) $2.72
D) $4.53

Question

Quizplus · Accepted Answer

Operating income = $4 million
Income tax rate = 40%
Net income = Operating income * (1 - Tax rate) = $4 million * (1 - 0.4) = $2.4 million

If Farar issues $6 million of 10% bonds, the interest expense will be $600,000 per year (10% of $6 million).

Net income after interest expense = $2.4 million - $600,000 = $1.8 million

Number of shares = 750,000

Earnings per share (EPS) = Net income after interest expense / Number of shares = $1.8 million / 750,000 = $2.4

Therefore, the projected EPS next year is $2.4. The closest answer choice is C, $2.72.