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Debt Versus Equity Financing

Wheeler Corporation is planning to expand its business and needs $30,000,000. The company believes that a 12-year term loan can be negotiated with a bank at an annual rate of 10%. Alternatively, an investment banking firm has indicated that it is willing to underwrite a common stock issue for a spread of 5%. Wheeler currently has 2,000,000 common shares outstanding.

(a) If new shares of Wheeler's stock can be sold for $30 per share, how many shares of stock must be sold to net the $30,000,000 that Wheeler needs, assuming out-of-pocket expenses of $600,000?

(b) If Wheeler's earnings before interest and taxes increase to $10,000,000 and the applicable tax rate is 34%, what would the earnings per share be under each financing alternative? (Assume annual interest before financing of $1,000,000)

(c) Compute the approximate market price of the common stock if the P/E ratio remains at 10 if new stock is issued but falls to 9.5 if the money is borrowed.

Solution Preview

(a) The spread will reduce Wheeler's net proceeds proportionately. Thus,
Net Proceeds=(Gross Proceeds*(1-spread))-Out-of-pocket expenses
$30,000,000 =(Gross Proceeds*(1-.05))-$600,000
$30,600,000 =Gross Proceeds*.95
$32,210,526.32= Gross Proceeds
...

Solution Summary

Wheeler Corporation is planning to expand its business and needs $30,000,000. The company believes that a 12-year term loan can be negotiated with a bank at an annual rate of 10%. Alternatively, an investment banking firm has indicated that it is willing to underwrite a common stock issue for a spread of 5%. Wheeler currently has 2,000,000 common shares outstanding.

(a) If new shares of Wheeler's stock can be sold for $30 per share, how many shares of stock must be sold to net the $30,000,000 that Wheeler needs, assuming out-of-pocket expenses of $600,000?

(b) If Wheeler's earnings before interest and taxes increase to $10,000,000 and the applicable tax rate is 34%, what would the earnings per share be under each financing alternative? (Assume annual interest before financing of $1,000,000)

(c) Compute the approximate market price of the common stock if the P/E ratio remains at 10 if new stock is issued but falls to 9.5 if the money is borrowed.

$2.19