Blooming Valley Custom Landscaping provides landscaping services to a variety of clients in southern Ontario. The company’s services include planting lawns and shrubs and installing outdoor lighting and irrigation systems, as well as constructing decks and gazebos. The company also remains very busy in the winter by using its trucks for snow removal. Blooming Valley would like to extend its operations into the northern United States, but Jack Langer, the owner, feels that the company would require at least $2 million in new capital before such a venture could be successful. Mr. Langer is excited about the prospects of expanding because his projections indicate that the company could earn an additional $750,000 in income before interest and taxes.
Currently, Blooming Valley has no long-term debt and is entirely owned by the Langer family, with 300,000 common shares outstanding. The company’s current income before tax is $900,000, with a tax rate of 25% that is not expected to change if the expansion goes ahead. As the family does not have enough money to finance the expansion, it needs to obtain outside financing. Mr. Langer is considering three financing options:
Option 1
The first option is to borrow, using a conventional bank loan. Interest on the loan would be 9% annually with an annual payment of principal and interest required on the anniversary date of the loan.
Option 2
The second possibility is to issue 100,000 common shares to a local venture capitalist. As part of the plan, the venture capitalist would be given a seat on the board of directors and would also have a say in the day-to-day running of the company.
Option 3
The final option is to sell 100,000 non-voting cumulative preferred shares. The preferred shares would have an annual dividend of $2.85. A number of investors have expressed interest in purchasing these shares.
Required:
a. Calculate the effect of each financing option on the company’s earnings per share. Which option will result in the highest earnings per share?
b. Recommend an option to Mr. Langer and explain your reasoning. Be sure to consider both quantitative and qualitative factors as part of your analysis.