Question: A firm that is currently financed solely through common equity has 2,000,000 shares outstanding that trade at $25 per share. To finance new investments, the firm wants to raise $6,000,000. The alternatives are to sell new common shares, to finance through convertible debentures, or to finance through ordinary debentures. Assume that new shares could be sold to net the firm $25 per share. The convertible debentures would carry interest of 1 0.5 percent and the straight debentures a coupon of 12 percent. Earnings before interest and taxes w ere $ 1 4,000,000 last year (year 0) and are expected to remain at that level for the coming year (year 1). After that time, the new investments are expected to be fully productive, resulting in EBIT for year 2 of $ 1 6,000,000. The corporate tax rate is 40 percent.
(a) Compute earnings per share for year 0.
(b) Compute earnings per share for years 1 and 2 for new commonshare financing, for financing through convertible debentures assuming that conversion has not taken place, and for financing through straight debentures.
(c) With financing through convertible debentures, compute earnings per share on a fully diluted basis for years 1 and 2 assuming alternative conversion ratios of
(i) 30 and
(ii) 35 per $ 1,000 debenture.
(d) Briefly discuss the implications of your findings, and suggest what trade-offs the firm faces in choosing between the various financing alternatives.