Case Scenario: 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.
1) Calculate the EPS (and dividends per share) under each plan after the expansion.
2) If the opportunity cost of equity stays at 10 percent when common stock is employed, what is the new market price per share?
3) 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?
4) 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?
5) Which financing plan do you recommend? Why?