Alternative Sources of Financing. The Drew Furniture Company is considering the introduction of a new product line. Plant and inventory expansion equal to 50 percent of present asset levels will be necessary to handle the anticipated volume of the new product line. New capital will have to be obtained to finance the asset expansion. Two proposals have been developed to provide the added capital.
1. Raise the $100,000 by issuing 10-year 12 percent bonds. This will change the capital structure from one with about 20 percent debt to one with almost 50 percent debt. The investment banking house estimates the price/earnings ratio, now 12 to 1, will be reduced to 10 to 1 if this method of financing is chosen.
2. Raise the $100,000 by issuing new common stock. The investment banker believes that the stock can be issued to yield $331 3 . The price/earnings ratio would remain at 12 to 1 if the stock were issued. The present market price is $36.
The company’s most recent financial statements are as follows:
Drew Furniture Company Balance Sheet As of December 31, 20XI
ASSETS EQUITIES
Current $ 65,000 Debt 5% $ 40,000
Plant and equipment 135,000 Common stock 100,000
Retained earnings 60,000
$200,000 $200,000
Income Statement For the Year Ended December 31, 20X1
Sales $600,000
Operating costs 538,000
Operating income $ 62,000
Interest charges 2,000
Net income before taxes $ 60,000
Federal income taxes 30,000
Net income $ 30,000
(a) The vice-president of finance asks you to calculate the earnings per share and the market value of the stock (assuming the price/earnings ratios given are valid estimates) for the two proposals assuming total sales (including the new product line) of: (1) $400,000; (2) $600,000; and (3) $800,000. Costs exclusive of interest and taxes are about 90 percent of sales. (b) Which proposal would you recommend? Your answer should indicate: (1) the criteria used to judge the alternatives; (2) a brief defense of the criteria used; and (3) the proposal chosen in accordance with the criteria. (c) Would your answer change if a sales level of $1,200,000 or more could be achieved?
Explain. (d ) What reasons(s) would the investment broker give to support the estimate of a lower price/earnings ratio if debt is issued? (CMA, adapted.)