Innovative Engineering Company was founded by two partners, Meredith Gale and Shelley Yeaton, shortly after they had graduated from engineering school. Within five years, the partners had built a thriving business, primarily through the development of a product line of measuring instruments based on the laser principle. Success brought with it the need for new permanent capital. After careful calculation, the partners placed the amount of this need at $1.2 million. This would replace a term loan that was about to mature and provide for plant expansion and related working capital.
Questions
1. For each of the four proposals, calculate the return on common shareholders' equity (net income after preferred dividends ÷ common shareholders' equity) that would be earned under each of the three income assumptions. Round calculations to the nearest $1,000 and 1/10 percent.
2. Calculate the pretax earnings and return on its $1.2 million investment to Arbor Capital Corporation under each of the four proposals. Assume that Arbor receives a dividend equal to its portion of common stock ownership times Innovative's net income after preferred dividends (if any); assume a "negative dividend" if Innovative has a net loss.
3. Were the partners correct in rejecting proposals A and B?
4. Comment on the likelihood that Innovative Engineering Company could find a more attractive financing proposal than proposal D.