Reference no: EM133062595
Assume that Yelp decides to launch a new website to market discount bookkeeping services to consumers. This chain, named Aladin, requires $500,000 of start-up capital. The founder contributes $375,000 of personal assets in return for $15,000 shares of common stock, but he must raise another $125,000 in cash. There are two alternative plans for raising the additional cash
- Under Plan A, the founder's share of income is affected because his share of common equirty will be decreased by the issuance of additional 3,750 Common Stock shares.
- Under Plan B, share of ownership will not change but we have to consider dividends that will be issued for Preferred Stock.
- We need to use a variation of the Basic Earnings per Share formula to evaluate the founder's expected return:
- Rate of Return on Beginning Equity = Share of Net Income Available to Founder
Founder's Intial Equity
1. The new business is expected to earn $72,000 of after-tax income in the first year,
- What share of income will be available to the funder under each alternative plan?
- What rate of return on beginning equity will the funder earn under each alternative plan?
Plan A would provide a 14.4% rate of return on beginning equity, and Plan B would provide a 16.5% rate of return on beginning equity.
- Which plan will provide the higher expected return?
Plan B would provide a higer return.
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Plan A
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Plan B
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Net income
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$72,000
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$72,000
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Less preferred dividends
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Net income for common shareholders
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Founder's share of common equity
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Founder's share of income after any preferred stock dividends
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Founder's initial equity
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Founder's return on equity
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2. The new business is expected to earn $16,800 of ater-tax net income in the first year,
- What rate of return on beginning equity will the founder earn under each alternative plan?
Plan A would provide a 3.36% rate of return on beginning equity and Plan B would provide a 1.81% rate of return on beginning equity.
- Which plan will provide the higher expected return?
Plan A would provide the higher rate of return.
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Plan A
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Plan B
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Net income
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$16,800
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$16,800
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Less preferred dividends
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Net income for common shareholders
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Founder's share of common equity
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Founder's share of income after any preferred stock dividends
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Founder's initial equity
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Founder's return on equity
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3. Which alternative do you think is best? Please explain.
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