Medical Goods is embarking on a massive expansion. Assume the plans call for opening 20 new stores during the next two years. Each store is scheduled to be 30% larger than the company’s existing locations, offering more items of inventory and with more elaborate displays. Management estimates that company operations will provide $1.0 million of the cash needed for expansion. Orchard Medical must raise the remaining $4.75 million from outsiders. The board of directors is considering obtaining the $4.75 million either by borrowing at 4% or by issuing an additional 200,000 shares of common stock. This year the company has earned $5 million before interest and taxes and has 200,000 shares of $1-par common stock outstanding.

The market price of the company’s stock is $23.75 per share. Assume that income before interest and taxes is expected to grow by 30% each year for the next two years. The company’s marginal income tax rate is 30%.

Requirements

1. Use Excel to evaluate the effect the two financing alternatives will have on Orchard’s net income and earnings per share two years from now.

2. Write a memo to Orchard’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?