Financial Leverage. Herken Company is a closely held corporation with a capital structure composed entirely of common stock and retained earnings. The stockholders have an agreement with the company that states the company will purchase the stock of a shareholder should a shareholder want to sell his or her holdings in the company. The agreement states that the stock will be purchased at a price equal to the stock’s previous year-end book value per share.
Early in October 20X1 Mrs. John Vader, a widow of one of Herken’s major stockholders, expressed an interest in selling her stock in accordance with the buy-back pricing arrangement. Mrs. Vader owns 600,000 shares of the 3 million shares of Herken Company common stock.
The board of directors has concluded that the company must replace the capital used to repurchase the shares. The board has assurances that it would be able to finance the acquisition of stock by borrowing the necessary funds on 10-year notes through private placement at an annual interest rate of 10 percent. Thus the company would have capital provided by debt and perhaps be able to take advantage of financial leverage.
The board and Mrs. Vader agreed that the exchange will take place on January 1, 20X2. The book value per share of common stock is projected to be $50 on December 31, 20X1.
The controller of Herken Company had prepared a forecast and pro forma statements for the 20X2 year.
An excerpt of the forecasted earnings statement for the year ended December 31, 20X2, is presented below (in thousands of dollars). Herken used a 40 percent income tax rate in the forecasted statement. The pro forma statements do not reflect the repurchase of Mrs. Vader’s shares or the new issue of debt required to pay for the shares.
Income before income taxes $50,000
Less income taxes (40%) 20,000
Net income $30,000
(a) Revise the excerpt from Herken Company’s forecasted earnings statement for the year ended December 31, 20X2, to reflect the long-term debt financing to be used to purchase Mrs. Vader’s common stock. Assume the 40 percent tax rate will still be applicable. (b) Explain the impact the long-term debt financing would have on Herken Company’s earnings per share and return on stockholders’ equity using the forecasted data for 20X2. (c) Identify and discuss the advantages and disadvantages of financial leverage for a company that has a capital structure similar to that of Herken Company before and after this long-term debt has been added. (CMA, adapted.)