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,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:
$\begin{array}{|l|r|r|}\hline&\text { Plan \#1 }& \text { Plan \#2 }\\\hline \text { Earnings before bond interest and taxes } & \$ 700,000 & \$ 700,000 \\\hline \text { Bond interest expense } & (60,000) & \\\hline \text { Income before taxes } & \$ 640,000 & \$ 700,000 \\\hline \text { Income taxes } & \underline{(224,000} & (245,000) \\\hline \text { Net income } & \$ 416,000 & \$ 455,000 \\\hline\\\hline \text { Equity } & \$ 8,000,000 & \$ 9,000,000 \\\hline \text { Return on Equity } & 5.2 \% & 5.06 \%\\\hline\end{array}$
Comment on the relative effects of each alternative,including when one form of financing is preferred to another.