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.
To begin, let's break down the problem step by step:
(a) To calculate the number of shares that must be sold to raise $30,000,000, we need to consider the cost per share and the additional expenses.
1. First, subtract the out-of-pocket expenses from the total amount needed:
$30,000,000 - $600,000 = $29,400,000
2. Next, divide the remaining amount by the price per share to find the number of shares:
$29,400,000 / $30 = 980,000 shares
Therefore, Wheeler needs to sell 980,000 shares of stock.
(b) To find the earnings per share (EPS) under each financing alternative, we need to calculate the net income for each option.
1. For the loan option:
- Calculate the interest expense:
$30,000,000 * 10% = $3,000,000 per year
- Calculate the net income:
$10,000,000 - $1,000,000 (interest expense) - ($10,000,000 - $1,000,000) * 34% (tax rate) = $5,340,000
- Divide the net income by the number of shares outstanding:
$5,340,000 / 2,000,000 shares = $2.67 earnings per share
2. For the stock issuance option:
- Calculate the net income:
$10,000,000 - $3,000,000 (interest expense) - ($10,000,000 - $3,000,000) * 34% (tax rate) = $5,340,000
- Divide the net income by the total number of shares after the issuance (2,000,000 + 980,000 shares):
$5,340,000 / (2,000,000 + 980,000) shares = $1.85 earnings per share
Therefore, the earnings per share would be $2.67 under the loan option and $1.85 under the stock issuance option.
(c) To calculate the approximate market price of the common stock, we need to multiply the earnings per share by the P/E ratio.
1. For the stock issuance option, the P/E ratio is 10:
Approximate market price = $1.85 EPS * 10 P/E ratio = $18.50
2. For the loan option, the P/E ratio is 9.5:
Approximate market price = $2.67 EPS * 9.5 P/E ratio = $25.36
Therefore, the approximate market price of the common stock would be $18.50 if new stock is issued and $25.36 if the money is borrowed.
Note: These calculations are based on the given information and assumptions provided.