Assume that Kelly Giard of Clean Air Lawn Care decides to launch a new retail chain to market electrical mowers. This chain, named Mow Green, requires $500,000 of start-up capital. Kelly contributes $375,000 of personal assets in return for 15,000 shares of common stock, but he must raise another $125,000 in cash. There are two alternative plans for raising the additional cash. Plan A is to sell 3,750 shares of common stock to one or more investors for $125,000 cash. Plan B is to sell 1,250 shares of cumulative preferred stock to one or more investors for $125,000 cash (this preferred stock would have a $100 par value, an annual 8% dividend rate, and be issued at par).
1. If the new business is expected to earn $72,000 of after-tax net income in the first year, what rate of return on beginning equity will Kelly earn under each alternative plan? Which plan will provide the higher expected return?
2. If the new business is expected to earn $16,800 of after-tax net income in the first year, what rate of return on beginning equity will Kelly earn under each alternative plan? Which plan will provide the higher expected return?
3. Analyze and interpret the differences between the results for parts 1 and 2.