Case Scenario: Alternative Financing Decision
Baker Company needs $1 million to expand its existing plant. Baker management is considering the following two alternative forms of financing:
1. At the beginning of 2014, issue $1 million of convertible, 10-year, 10 percent bonds. Each $1,000 bond can be converted into 20 shares of Baker $10 par value common stock. The conversion may take place any time after three years.
2. At the beginning of 2014, issue 10,000 shares of $100 par value, $10, redeemable preferred stock. The preferred is redeemable at $102 ten years from the date of issue.
Baker's management is concerned about the effects of the two alternatives on cash flows, their financial statements, and future financing for other planned expansion activities. Also, existing debt covenants restrict the debt-to-equity ratio to 2:1; $1 million in new debt would cause the debt-to-equity ratio to be close to 2:1. Baker believes that either the bonds or the preferred stock could be sold at par value. Their income tax rate is 34 percent.
Baker Company common stock is currently selling for $45 per share.
Required:
1. Compare the effects of the two financing alternatives on Baker Company's balance sheet, income statement, and cash flows under current U.S. GAAP. Your comparison should consider 2014 and future years, the potential conversion of the bonds, and the debt covenant restrictions.
2. If the FASB were to decide to recognize the value for conversion (conversion feature) as equity, would this have an impact on Baker Company's decision? How would Baker's financial statements be affected if it chose the convertible bond alternative? Would the decision to select convertible bonds versus redeemable preferred stock be affected, especially in light of the concern regarding the debt covenant restrictions?