A company is trying to decide whether to invest USD 2 million on plant expansion and USD 1 million to finance a related increase in inventories and accounts receivable. The USD 3 million expansion is expected to increase business volume substantially. Profit forecasts indicate that income from operations will rise from USD 1.6 million to USD 2.4 million. The income tax rate will be about 40 percent. Net income last year was USD 918,000. Interest expense on debt now outstanding is USD 70,000 per year. There are 200,000 shares of common stock currently outstanding. The USD 3 million needed can be obtained in two alternative ways:
Finance entirely by issuing additional shares of common stock at an expected issue price of USD 75 per share.
•Finance two-thirds with bonds, one-third with additional stock. The bonds would have a 20-year life, bear interest at 10 percent, and sell at face value. The issue price of the stock would be USD 80 per share. Should the investment be made? If so, explain which financing plan you would recommend. (Hint: Calculate earnings per share for last year and for future years under each of the alternatives.)