Interest-bearing note Example Exercise 1 Financing Corporations Financing Options: Short-term debt such as purchasing goods or services on account Long-term debt, such as issuing bonds or notes payable Equity, such as issuing common or preferred stock Corporations finance their operations using three sources. These include: [CLICK] short-term debt such as purchasing goods or services on account [CLICK] long-term debt, such as issuing bonds or notes payable [CLICK] and equity, such as issuing common or preferred stock A bond is a form of an interest-bearing note. [CLICK] As creditors of the corporation, bondholder claims on the corporation’s assets rank ahead of other stockholders. Interest-bearing note

Example Exercise 1 Financing Corporations Huckadee Corporation is considering the following plans to issue debt and equity: Assume that Huckadee Corporation is considering the plans shown to finance $4 million. Each of these plans finances some of the corporation’s operations by issuing common stock. However, the percentage financed varies from 100% in plan 1 [CLICK] to 25% in plan 3 [CLICK]

Example Exercise 1 Financing Corporations Assume the following: Earnings before interest and income taxes are $800,000 The tax rate is 40% All bonds or stocks are issued at their par or face amount Assume [CLICK] that earnings before interest and taxes are $800,000, [CLICK] the tax rate is 40% and [CLICK] that all bonds or stocks are issued at their par or face amount.

Example Exercise 1 Financing Corporations Let’s look at the effect on net income and earnings per share. Remember that interest on bonds is deductible so Income before income tax is $560,000 for Plan 3 [CLICK] after deducting interest on bonds while it’s $800,000 for Plans 1 and 2 [CLICK] since there’s no interest on stock issued.

Example Exercise 1 Financing Corporations This results in a smaller amount of net income for plan 3 due to the deduction of interest on the bonds. It’s $336,000 for plan 3 [CLICK] and $480,000 for each of Plans 1 and 2. [CLICK]

Example Exercise 1 Financing Corporations Next, we’ll determine the amount of net income available to the common stockholders in order to compute earnings per share. We’ll deduct the dividends on preferred stock for Plans 2 and 3 only since there wasn’t any preferred stock issued for plan 1.

Example Exercise 1 Financing Corporations Then we’ll divide the net income available to common stockholders by the shares of common stock outstanding for each of the plans to determine earnings per share [CLICK]. Notice the difference in amounts for each of the plans. It’s highest for Plan 3 and thus, the most attractive for common stockholders.

Example Exercise 1 Financing Corporations If smaller earnings before interest and income taxes occur, in this case $440,000 rather than the $800,000 shown in the previous example, Plans 1 and 2 [CLICK] become more attractive to common stockholders.

Example Exercise 1 1 Let’s look at the example exercise for Gonzales Company. They are considering the one of the two financing plans shown. We need to determine earnings per share under each of the two plans assuming income before interest and taxes is $750,000.

Example Exercise 1 1 First, we’ll deduct interest on the bonds for plan 2. This is calculated as $2 million times 10%. [CLICK] $2,000,000 x 10%

Example Exercise 1 1 Then we’ll deduct income taxes determined at 40% to arrive at the net income for each plan.

Example Exercise 1 1 Since there aren’t any dividends on preferred stock, the earnings available to the common shareholders are $450,000 for Plan 1 and $330,000 for Plan 2. Dividing these amounts by the number of common shares issued for each plan, we get earnings per share of $1.50 for Plan 1 and $3.30 for Plan 2.

Example Exercise 1  For Practice: PE 1A, PE 1B 1 1 Refer to Practice Exercises PE 1A and PE 1B for a look at alternative financing plans. 1A, 1B  For Practice: PE 1A, PE 1B