Acct 557 Chapter 10 Homework Exercise 10 9 Global Airlines

Acct 557 Chapter 10 Homeworkexercise 10 9global Airlines Is Considerin

Global Airlines is considering two alternatives for financing a purchase of a fleet of airplanes: issuing 60,000 shares of common stock at $40 per share, or issuing 10%, 10-year bonds at face value for $2,400,000. The company expects to earn $800,000 before interest and taxes from the purchase and has a tax rate of 30%. Prior to new financing, there are 90,000 shares of common stock outstanding. Determine the effect on net income and earnings per share for these two methods of financing, rounding earnings per share to two decimal places.

Paper For Above instruction

The decision of how to finance a substantial asset purchase such as a fleet of airplanes has significant implications for a company's financial health and shareholder value. In this context, Global Airlines is evaluating two alternatives: issuing equity or debt. Each option has unique impacts on net income, earnings per share (EPS), and overall financial leverage, which are critical considerations for management and investors.

Analysis of Financing Alternatives

The first alternative involves issuing 60,000 shares of common stock at $40 per share. Since no dividends are paid or contemplated, this option results in no immediate expense related to dividend payments, but it does dilute existing shares outstanding. The total proceeds from issuing stock would be:

  • 60,000 shares × $40 = $2,400,000

This amount matches the bond issuance value, making a direct comparison feasible. The purchase generates an $800,000 pre-tax profit associated with the new fleet, which directly impacts net income after taxes.

Since there are no dividends, the net income attributable to shareholders is calculated as:

  • Pre-tax earnings: $800,000
  • Less: Taxes (30%) of $240,000 (30% of $800,000): $240,000
  • Net income: $560,000

Assuming the existing 90,000 shares are unaffected by the new stock issuance (which is not the case here, because additional shares are issued), the calculation of EPS with the new shares issued is:

  • New shares outstanding: 90,000 + 60,000 = 150,000
  • EPS: $560,000 / 150,000 ≈ $3.73

This indicates earnings are distributed over a larger number of shares, leading to a dilute EPS.

The second alternative is issuing bonds at face value for $2,400,000 with a 10% interest rate over 10 years. The annual interest expense before taxes would be:

  • Interest expense: 10% of $2,400,000 = $240,000

The net income after accounting for interest and taxes is:

  • Pre-tax earnings: $800,000
  • Less: interest expense: $240,000
  • Taxable income: $560,000
  • Taxes (30%): $168,000
  • Net income: $392,000

In terms of EPS, the total shares outstanding prior to issuance remains at 90,000, assuming no new shares are issued in debt financing. Therefore, the EPS is:

  • EPS: $392,000 / 90,000 ≈ $4.36

Comparison and Conclusion

The analysis reveals that, under these assumptions, debt financing yields higher net income and EPS relative to equity financing. The key reasons include the tax shield benefit of interest expense, which reduces taxable income, enhancing net income. Conversely, issuing new equity dilutes existing shareholders' ownership but does not increase debt obligations and interest expenses.

This scenario underlines the importance of considering the trade-offs between leverage and dilution. Companies often weigh the higher EPS and tax benefits associated with debt against the potential risks of increased financial leverage and obligations. Optimal capital structure decisions require careful analysis of these factors, especially for large investments like airline fleets that significantly impact cash flow and risk profiles.

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