Homework Assignment 3

Situation 1;
Determine for each plan the earnings per share of common stock, assuming that the income befor
e bond interest and income tax is $1,500,000.
Plan 1 Plan 2 Plan 3
5% bonds $5,000,000
Preferred 8% stock, $40 par $5,000,000 $5,000,000
Common stock, $10 par $15,000,000 $10,000,000 $5,000,000
Total $15,000,000 $15,000,000 $15,000,000
Earnings before interest and income tax $1,500,000 $1,500,000 $1,500,000
Deduct interest on bonds $250,000
Income before income tax $1,500,000 $1,500,000 $1,250,000
Deduct income tax $600,000 $600,000 $500,000
Net income $900,000 $900,000 $750,000
Dividends on preferred stock $400,000 $400,000
Available for dividends on common stock $900,000 $500,000 $350,000

Shares of common stock outstanding (available
dividend on common stock / number of shares of
common stock at $10 par)
$900,000
1,500,000
$500,000
1,000,000
$350,000
500,000
Earnings per share on common stock $0.60 $0.50 $0.70

In this situation, plan 3 has the highest yield as it gives the highest EPS on common stock. For
this reason, plan 3 will be the most attractive plan for the common stock holders. But if the
earning will be lesser than the mentioned, stockholders will prefer plan 1 and other two plans
will become less attractive for them. But directors still have to consider a few more factors
before deciding to issue equity or debt.
Situation 2;
Determine for each plan the earnings per share of common stock, assuming that the income befor
e bond interest and income tax is $900,000.

Plan 1 Plan 2 Plan 3
5% bonds $5,000,000
Preferred 8% stock, $40 par $5,000,000 $5,000,000
Common stock, $10 par $15,000,000 $10,000,000 $5,000,000
Total $15,000,000 $15,000,000 $15,000,000
Earnings before interest and income tax $900,000 $900,000 $900,000
Deduct interest on bonds $250,000
Income before income tax $900,000 $900,000 $650,000
Deduct income tax , 40% $360,000 $360,000 $260,000
Net income $540,000 $540,000 $390,000
Dividends on preferred stock $400,000 $400,000
Available for dividends on common stock $540,000 $140,000 $-10,000

Shares of common stock outstanding (available
dividend on common stock / number of shares of
common stock)
$540,000
1,500,000
$140,000
1,000,000
$-10,000
500,000
Earnings per share on common stock $0.36 $0.14 $0.02(loss)

In this situation, plan 3 goes in loss. And thus, plan 1 and 2 will attract the more stock holders.
When interest fall down, most of the organizations issue debts instead of equity.