Penny Arcades, Inc., is trying to decide between the following two alternatives to finance its new $30 million gaming center:
a. Issue $30 million of 5% bonds at face amount.
b. Issue 1 million shares of common stock for $30 per share.
1. Assuming bonds or shares of stock are issued at the beginning of the year, complete the income statement for each alternative. (Enter your answer in dollars, not millions. (i. e., $5.5 million should be entered as 5,500,000). Round your "Earnings per Share" to 2 decimal places. Round your "Earnings per Share" to 2 decimal places.)

Issue Bonds Issue stock
Operating income 10,500,0000 10,500,5000
Interest expense (bonds only)
Income before tax
Income tax expense (40%)
Net Income
Number of shares 3,500,0000 4,500,000
Earnings per share

2. Which alternative results in the highest earnings per share?
Issue bonds
Issue stock

Based on the information the Earnings per share is :

Issue bonds $1.71 per share

Issue stock $1.40 per share

1. Earning per share

                            Issue bonds  Issue stock

Operating income$10,500,000$10,500,000

Interest expense (Note only) ($525,000)0

Income before tax$9,975,000$10,500,000

($10,500,000-$525,000=$9,975,000)

Income tax expense (40%) ($3,990,000)($4,200,000)

Net income$5,985,000$6,300,000

($9,975,000-$3,990,000)  ($10,500,000-$4,200,000)

Number of shares3,500,000  4,500,000

Earnings per share (Net income/Number of shares)$1.71$1.40

($5,985,000/3,500,000)   ($6,300,000/4,500,000)

Interest expense for Issue bonds

Interest expense=$30,000,000×5%

Interest expense=$525,000

Income tax expense for Issue bonds

Income tax expense=40%×($10,500,000-$525,000)

Income tax expense=40%× $9,975,000

Income tax expense=$3,990,000

Income tax expense for Issue stock

Income tax expense=40%×$10,500,000

Income tax expense=$4,200,000

2. Based on the above calculation the alternative that results in the highest earnings per share is issue bonds.

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Solution:

Alternative 1 ( if finance raised by bond issue)    

                             $m                 (calculation)

Operating Income    10.5

interest expense:      1.5                 (30 * 5%)

profit before tax         9                  (10.5-1.5)

Tax                            360                 (9*40)

Profit after Tax        6.58                 (9-6.58)

earnings per share   2.42               (6.58/3.01)

Alternative 2 ( if finance raised by share issue)    

                             $m                (calculation)

Operating Income    10.5              (as given in question)

interest expense:         - -              (as no bond issue so no interest payment)

profit before tax       10.5                

Tax                           420               (10.5 * 40)

Profit after Tax        409.5              (10.5 - 420)

(or net profit)  

earnings per share   1.88                (7.54/4.01)    

as new shares will be issued and will thus increase  number of shares and lower earnings per share

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