question archive Mack Company, HappyDay's branch, plans to invest $50,000 in land that will produce annual rent revenue equal to 15 percent of the investment, starting on January 1, Year 3
Mack Company, HappyDay's branch, plans to invest $50,000 in land that will produce annual rent revenue equal to 15 percent of the investment, starting on January 1, Year 3
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Mack Company, HappyDay's branch, plans to invest $50,000 in land that will produce annual rent revenue equal to 15 percent of the investment, starting on January 1, Year 3. The revenue will be collected in cash at the end of each year, starting December 31, Year 3. Mack can obtain the cash necessary to purchase the land from two sources. Funds can be obtained by issuing $50,000 of 10 percent, five-year bonds at their face amount. Interest due on the bonds is payable on December 31 of each year with the first payment due on December 31, 2021. Alternatively, the $50,000 needed to invest in land can be obtained from equity financing. In this case, the stockholders (holders of the equity) will be paid a $5,000 annual cash dividend. Mack Company is in a 30 percent income tax bracket.
income statement and statement of cash flows for Mack Company for Year 3 under the two alternative financing proposals (debt financing and equity financing).
short memorandum explaining why one financing alternative provides more net income but less cash flow than the other.
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Mack Company
Year 3
Income Statement
Rental Income $7,500
Interest expense (1,000)*
Income before tax 6,500
Income tax expense (1,950)**
Net income $4,550
*($50,000*10%/5years) = $1,000
**($6,500*30%) = $1,950
Mack Company
Year 3
Cash Flow
Income before tax $6,500
Adjustment for interest expense 1,000
Cash generated from operations 7,500
Income tax paid (1,950)
Net cash flows from operating activities 5,550
Cash flow from financing activity:
Availment of loans 50,000
Increase in Cash $55,550
EQUITY FINANCING
Mack Company
Year 3
Income Statement
Rental Income $7,500
Income tax expense (2,250)*
Net income $5,250
*($7,500*30%) = $2,250
Mack Company
Year 3
Cash Flow
Income before tax $7,500
Income tax paid (1,950)
Net cash flows from operating activities 5,250
Cash flow from financing activity:
Cash dividend paid (5,000)
Increase in Cash $250
SHORT MEMORANDUM
Equity financing is more expensive compared to debt financing due to the fact that in the latter, as soon as the debt was fully paid, there are no more obligations and the interest expense is deductible thereby reduces income tax expense. If the company uses equity financing, the company is required to pay dividend whenever it was earning.
