Several investors are in the process of organizing a new company. The investors believe that $1,000,000 will be needed to finance the new company’s operations, and they are considering three methods of raising this amount of money.

• Method A: All $1,000,000 can be obtained through issue of common shares.

• Method B: $500,000 can be obtained through issue of common shares and the other $500,000 can be obtained through issue of $100 par value, 8% preferred shares.

• Method C: $500,000 can be obtained through issue of common shares, and the other $500,000 can be obtained through issue of bonds carrying an interest rate of 8%.

The investors organizing the new company are confident that it can earn $170,000 each year before interest and taxes. The tax rate will be 30%.

Required:

1. Assuming that the investors are correct in their earnings estimate, compute the net income that would go to the common shareholders under each of the three financing methods listed above.

2. Using the income data computed in part (1), compute the return on common equity under each of the three methods.

3. Why do methods B and C provide a greater return on common equity than method A? Why does method C provide a greater return on common equity than method B?