Over the Hill Savings has been told by examiners that it needs to raise an additional $8 million in long-term capital. Its outstanding common equity shares total 5.4 million, each bearing a par value of $1. This thrift institution currently holds assets of nearly $2 billion, with $135 million in

Question

Over the Hill Savings has been told by examiners that it needs to raise an additional $8 million in long-term capital. Its outstanding common equity shares total 5.4 million, each bearing a par value of $1. This thrift institution currently holds assets of nearly $2 billion, with $135 million in equity. During the coming year, the thrift’s economist has forecast operating revenues of $180 million, of which operating expenses are $25 million plus 70% of operating revenues

Accepted Answer

Among the options for raising capital considered by management are (a) selling $8 million in common stock, or 320,000 shares at $25 per share; (b) selling $8 million in preferred stock bearing a 9 percent annual dividend yield at $12 per share; or (c) selling $8 million in 10-year capital notes with a 10 percent coupon rate. Which option would be of most benefit to the stockholders? (Assume a 34% tax rate) What happens if operating revenue more than expected ($225 million rather than $180 million)? What happens if there is a slower-than-expected volume of revenues (only $110 million instead of $180 million)? Please explain.

	(a) Sale of Common Stock at $25 per share	(b) Sale of 9% Preferred Stock at $12 per share	(c) Sale of 10% Capital Notes
Operating revenues	$180,000,000	$180,000,000	$180,000,000
Operating expenses	151,000,000	151,000,000	151,000,000
Net revenues	$ 29,000,000	$ 29,000,000	$ 29,000,000
Interest on capital notes			800,000
Before-tax income	$29,000,000	$29,000,000	$28,200,000
Estimated income taxes	9,860,000	9,860,000	9,588,000
After-tax income	$ 19,140,000	$ 19,140,000	$ 18,612,000
Preferred stock dividends		720,000
Net income for common stockholders	$ 19,140,000	$ 18,420,000	$ 18,612,000
Shares of common stock outstanding	5,720,000	5,400,000	5,400,000
Earnings per share of common stock	$ 3.35	$3.41	$3.45

In this case sale of the debt would yield the highest EPS for the bank's shareholders

Because of the dilution effect of issuing stock.

If operating revenue rose to $225 million the situation would be the following:

	(a) Sale of Common Stock at $25 per share	(b) Sale of 9% Preferred Stock at $12 per share	(c) Sale of 10% Capital Notes
Operating revenues	$225,000,000	$225,000,000	$225,000,000
Operating expenses	182,500,000	182,500,000	182,500,000
Net revenues	$ 42,500,000	$ 42,5000,000	$ 42,500,000
Interest on capital notes			800,000
Before-tax income	$42,500,000	$42,500,000	$41,700,000
Estimated income taxes	14,450,000	14,450,000	14,178,000
After-tax income	$ 28,050,000	$ 28,050,000	$ 27,522,000
Preferred stock dividends		720,000
Net income for common stockholders	$ 28,050,000	$ 27,330,000	$ 27,522,000
Shares of common stock outstanding	5,720,000	5,400,000	5,400,000
Earnings per share of common stock	$4.90	$5.06	$5.1

And again the capital notes would be the best option, although the preferred stock comes closer this time.

If operating revenues drop to $110 million, then the situation would be the following

	(a) Sale of Common Stock at $25 per share	(b) Sale of 9% Preferred Stock at $12 per share	(c) Sale of 10% Capital Notes
Operating revenues	$110,000,000	$110,000,000	$110,000,000
Operating expenses	102,000,000	102,000,000	102,000,000
Net revenues	$ 8,000,000	$ 8,000,000	$ 8,000,000
Interest on capital notes			800,000
Before-tax income	$8,000,000	$8,000,000	$7,200,000
Estimated income taxes	2,720,000	2,720,000	2,448,000
After-tax income	$ 5,280,000	$ 5,280,000	$ 4,752,000
Preferred stock dividends		720,000
Net income for common stockholders	$ 5,280,000	$ 4,560,000	$ 4,752,000
Shares of common stock outstanding	5,720,000	5,400,000	5,400,000
Earnings per share of common stock	$ 0.92	$0.84	$ 0.88

In this case issuing the common stock is the best alternative from the point of view of the common stockholders.

Question 15.P.9: Over the Hill Savings has been told by examiners that it nee...

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