Wheeler Corporation is planning to expand its business and needs $30,000,000. The company believes that a 12-year term loan can be negotiated with a bank at an annual rate of 10%. Alternatively, an investment banking firm has indicated that it is willing to underwrite a common stock issue for a spread of 5%. Wheeler currently has 2,000,000 common shares outstanding.
(a) If new shares of Wheeler's stock can be sold for $30 per share, how many shares of stock must be sold to net the $30,000,000 that Wheeler needs, assuming out-of-pocket expenses of $600,000?
(b) If Wheeler's earnings before interest and taxes increase to $10,000,000 and the applicable tax rate is 34%, what would the earnings per share be under each financing alternative? (Assume annual interest before financing of $1,000,000)
(c) Compute the approximate market price of the common stock if the P/E ratio remains at 10 if new stock is issued but falls to 9.5 if the money is borrowed.
(a) If new shares of Wheeler's stock can be sold for $30 per share, how many shares of stock must be sold to net the $30,000,000 that Wheeler needs, assuming out-of-pocket expenses of $600,000?
Apparently, Wheeler needs $30,600,000.
30,600,000 / 30 = ?
(a) To calculate the number of shares of stock that need to be sold to net $30,000,000, we can subtract the out-of-pocket expenses from the total amount needed.
Net amount needed = $30,000,000 - $600,000 = $29,400,000
Next, we divide the net amount needed by the selling price per share to find the number of shares required:
Number of shares = $29,400,000 / $30 = 980,000 shares
Therefore, Wheeler Corporation would need to sell 980,000 shares of stock to achieve the desired funds.
(b) Before calculating the earnings per share (EPS) under each financing alternative, we need to determine the interest expense for each option.
For the loan option, the annual interest before financing is $1,000,000. Assuming a tax rate of 34%, the after-tax interest expense would be:
After-tax interest expense for loan = $1,000,000 * (1 - 0.34) = $660,000
For the common stock option, there is no interest expense since it involves equity financing.
To calculate the earnings per share under each financing alternative, we use the formula:
EPS = (Earnings before interest and taxes - Interest expense) / Number of shares
For the loan option:
EPS_loan = ($10,000,000 - $660,000) / 2,000,000 = $4.67 per share
For the common stock option:
EPS_common stock = ($10,000,000 - 0) / (2,000,000 + Number of new shares)
Since we were given that the number of new shares required is 980,000, we can substitute this value:
EPS_common stock = ($10,000,000 - 0) / (2,000,000 + 980,000) = $3.23 per share
Therefore, the earnings per share would be $4.67 under the loan option and $3.23 under the common stock option.
(c) To compute the approximate market price of the common stock, we use the price-to-earnings (P/E) ratio and the earnings per share.
For the stock issuance option with a P/E ratio of 10:
Market price = P/E ratio * EPS_common stock = 10 * $3.23 = $32.30 per share
For the loan option with a P/E ratio of 9.5:
Market price = P/E ratio * EPS_loan = 9.5 * $4.67 = $44.37 per share
Therefore, the approximate market price of the common stock would be $32.30 if new stock is issued and $44.37 if the money is borrowed.