Question: Baja Airlines is considering these two alternatives for financing the purchase of a fleet of airplanes:
1. Issue 50,000 shares of common stock at $40 per share. (Cash dividends have not been paid nor is the payment of any contemplated.)
2. Issue 12%, 10-year bonds at face value for $2,000,000. It is estimated that the company will earn $800,000 before interest and taxes as a result of this purchase. The company has an estimated tax rate of 30% and has 90,000 shares of common stock outstanding prior to the new financing.
Instructions: Determine the effect on net income and earnings per share for
(a) issuing stock and
(b) issuing bonds.
Assume the new shares or new bonds will be outstanding for the entire year.