Marcell Medical Goods is embarking on a massive expansion. Assume the plans call for opening 40 new stores during the next two years. Each store is scheduled to be 35% larger than the company’s existing locations, offering more items of inventory and with more elaborate displays. Management estimates that company operations will provide $2.5 million of the cash needed for expansion. Marcell Medical must raise the remaining $7.75 million from outsiders.
The board of directors is considering obtaining the $7.75 million either through borrowing at 5% or by issuing an additional 100,000 shares of common stock. This year the company has earned $3 million before interest and taxes and has 100,000 shares of $1-par common stock outstanding. The market price of the company’s stock is $77.50 per share. Assume that income before interest and taxes is expected to grow by 10% each year for the next two years. The company’s marginal income tax rate is 35%.
1. Use Excel to evaluate the effect of the above projected alternatives on net income and earnings per share two years from now.
2. Write a memo to Marcell’s management discussing the advantages and disadvantages of borrowing and of issuing common stock to raise the needed cash. Which method of raising the funds would you recommend?