Owakonze Inc. (Owakonze), a privately owned corporation, is in need of $5,000,000 to finance an expansion of its operations. Management is considering three financing alternatives:
i. Issue 250,000 common shares to a group of private investors for $20 per share. In recent years, dividends of $0.75 per share have been paid on the common shares.
ii. Issue 50,000 cumulative preferred shares with an annual dividend of $6 per share for $100 per share. The preferred shares are redeemable after eight years for $112 per share.
iii. Issue a $5,000,000 bond with a coupon rate of 8.5 percent per year and maturity in 12 years.
It's now late July 2017. Owakonze's year-end is July 31. Owakonze plans to raise the needed money at the beginning of its 2018 fiscal year, but management wants to know the financial statement effects and implications of each alternative. Owakonze's accounting department has provided the right-hand side of the balance sheet as of July 31, 2017 and a summarized projected income statement for the year ended July 31, 2018. The projected statements don't reflect any of the proposed financing alternatives.
One of Owakonze's existing loans has a covenant that requires the debt-to-equity ratio be below 1:1. Owakonze has a tax rate of 15 percent.
Summarized projected income statement for the year ended July 31, 2018
Revenue................. $ 5,600,000
Income tax expense............ 150,000
Net income.............. $ 850,000
Liabilities and shareholders’ equity as of July 31, 2017
Liabilities................. $ 7,500,000
Preferred shares (200,000 shares authorized, 0 issued)..0
Common shares (unlimited number
of shares authorized, 1,000,000 outstanding) ..... 8,500,000
Retained earnings............... 7,000,000
Total liabilities and shareholders’ equity....... $23,000,000
a. Calculate projected net income for Owakonze under the three financing alternatives.
b. Calculate basic earnings per share and return on shareholders' equity under the three financing alternatives.
c. Prepare a report to Owakonze's management explaining the effect of each of the financing alternatives on the financial statements. Include in your report a discussion of the pros and cons of each financing alternative. Also, make a recommendation as to which alternative it should choose. Support your recommendation.