Wendy Prince has consulted you about the possibility of investing in one of three companies (Apple, Inc., Baker Company, or Cookie Corp.) by buying its common stock. The companies” investment shares are selling at about the same price. The long-term capital structures of the companies alternatives are as follows:
|
Apple, |
Baker |
Cookie |
|
|
Inc. |
Company |
Corp. |
|
|
Bonds with a 10% interest rate |
$2,400,000 |
||
|
Preferred stock with an 8% |
$2,400,000 |
||
|
dividend rate |
|||
|
Common stock, $10 par value |
$4,800,000 |
2400000 |
24,00,000 |
|
Retained earnings |
3,84,000 |
3,84,000 |
3,84,000 |
|
Total long-term equity |
$5,184,000 |
$5,184,000 |
$5,184,000 |
|
Number of common shares |
4,80,000 |
2,40,000 |
2,40,000 |
|
outstanding |
|||
Prince has already consulted two investment advisers. One adviser believes that each of the companies will earn USD 300,000 per year before interest and taxes. The other adviser believes that each company will earn about USD 960,000 per year before interest and taxes. Prince has asked you to write a report covering these points:
a. Compute each of the following, using the estimates made by the first and second advisers.
(a)Earnings available for common stockholders assuming a 40 percent tax rate.
(b)EPS of common stock.
(c)Rate of return on total stockholders” equity.
b. Which stock should Prince select if she believes the first adviser?
c. Are the stockholders as a group (common and preferred) better off with or without the use of long-term debt in the companies?