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Debt Versus Equity Financing

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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.

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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
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The answer is based on the following reference material:

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