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Chapter 2.2® - Example of Return on Equity & Raising Capital through Bonds & Shares and its Effects on Return on Equity - Issuance of Common Shares versus Bonds Payable

Let’s consider Shab Networks Corp has income before tax of \$200,000 and has no interest expense. The company has \$1 million in equity and is planning a \$500,000 expansion to meet increasing demand for its products/services. Shab Networks predicts this \$500,000 investment will result in additional net income of \$135,000 per year before paying interest or taxes. Shab Networks sat down with its board of directors and Controllers group to discuss this issue and considered 3 options:

 a) Option A is to not expand b) Option B is to expand, raise the \$500,000 by issuing its Class A common stock c) Option C is to sell \$500,000 worth of bonds paying 10% annual coupon rate, resulting in interest expense of \$50,000 per year.

Tabular Analysis of Income before Taxes & Interest Expense

 Income before Taxes & Interest expense (Option A) \$200,000 (Option B) \$335,000 (Option C) \$335,000 Interest Expense \$0 \$0 (\$50,000) Income before Tax \$200,000 \$335,000 \$285,000 Equity \$2,000,000 \$2,500,000 \$2,000,000 Return on Equity (Net Income / Equity) 10% 13.4% 14.25%

The tabular analysis above shows the corporation will earn a higher return on equity (14.25%) if it expands by issuing \$500,000 worth of bonds, even though its net income is lower than Option B, totalling \$285,000 while Option B has net income of \$335,000. Thus, the best option for this organization is option C which is to sell \$500,000 worth of bonds and paying a 10% annual coupon rate with an interest payable of \$50,000 per year.

This above graph shows the raise of \$500,000 via common class stock (Option B) & its associated rate of return of 13.40%. It also shows raise of capital via bond issuance and its return of 14.25%. Note that the income is higher under Option B of common stock issuance (\$335,000) while the issuance of bonds yields a net income of \$285,000 however the return on equity calculation (net income / equity) is higher for Option C due to the \$500,000 bond payable allocated to the liabilities section of the balance sheet, as opposed to it being put under shareholder's equity under Option B; you can verify this by checking the equity is \$2,500,000 under Option B while it is \$2,000,000 under Option C.