A Corporation Plans to Invest $1 Million in Oil Exploration

Essay

A corporation plans to invest $1 million in oil exploration. The corporation is considering two plans to raise the money. Under Plan #1, bonds with a contract rate of interest of 6% would be issued. Under Plan #2, 50,000 additional shares of common stock would be issued at $20 per share. The corporation currently has 300,000 shares of stock outstanding, and it expects to earn $700,000 per year before bond interest and income taxes. The net income and return on investment for both plans is shown below:
$\begin{array}{|l|c|c|}\hline &\underline{\text { Plan \#1 }} &\underline{\text { Plan \#2 }}\\ \hline \text { Earnings before bond interest and taxes. } & \$ 700,000& \$ 700,000 \\\hline \text { Bond interest expense } & (60,000) &\\\hline \text { Income before } & \$ 640,000&\$700,000 \\\hline\end{array}$ $\begin{array}{|l|c|c|}\hline \text { Income before taxes } & \$ 640,000 & \$ 700,000 \\\hline \text { Income taxes} & (224,000) & (245,000) \\\hline \text { Net income. } & \$ 416,000 & \$ 455,000 \\\hline\\\hline \text { Equity. } & \$ 8,000,000 & \$ 9,000,000 \\\hline \text { Return on Equity. } & 5.2 \% & 5.06 \% \\\hline\end{array}$ Comment on the relative effects of each alternative, including when one form of financing is preferred to another.