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Nova Scotia General and Investment

Nova Scotia General is an all-equity firm. The firm has 200,000 shares of common stock outstanding, the
EPS is $2, and all earnings are paid out to the shareholders as dividends. The current market value of the
stock is $20 per share, and the opportunity cost of equity capital is 10 percent. General is considering two
alternative plans to raise $3 million for a new and highly promising investment project, as follows:
Plan A: Issue 150,000 more shares of common stock at $20 per share.
Plan B: Issue $3 million of 9 percent coupon rate bonds.
After the new investment, General expects EBIT to be $1,400,000. The tax rate is 35 percent.
a) Calculate the EPS (and dividends per share) under each plan after the expansion.
b) If the opportunity cost of equity stays at 10 percent when common stock is employed, what is the new
market price per share?
c) If bonds are used, the opportunity cost of equity capital increases to 12 percent. What is the new
market price per share under that plan?
d) Explain why the market price calculated in (b) is higher than the beginning market price of $20. Then
explain why the market price calculated in c) is greater than that calculated in b). How does this
relate to the basic business of the firm, and the financing employed?
e) Which financing plan do you recommend? Why?

Solution Preview

a)
Plan A:
EBIT = 1,400,000
Interest = 0
EBT=1,400,000
Tax @35%=490,000
EAT=910000
No of shares=200000+150000=350000
EPS=$2.60
Since all earnings are paid out as dividend DPS will be same as EPS, So
DPS=$2.60

Plan B:
EBIT = 1,400,000
Interest = 3,000,000*9%=270,000
EBT=1,130,000
Tax @35%=395,500
EAT=734500
No of shares=200000
EPS=$3.6725
Since all earnings are paid out as dividend DPS will be same as EPS, So
DPS=$3.6725

b) Since all earnings are paid out as dividend, the growth rate in dividends will be zero
P=D0*(1+g)/(k-g) = 2.60*(1+0%)/(10%-0%)=$26.00

c) Since ...

Solution Summary

This solution shows step-by-step calculations to determine the EPS, dividends per share, market price per share, and recommends a strategy plan. Justifications are also included.

$2.19