ANALYZING FINANCING ALTERNATIVES
Significant changes in the capital stock accounts can impact a shareholder’s ownership
interest in the firm. Such changes in the capital accounts can occur when there are sig-
nificant corporate financing transactions. Shareholders should analyze the impact of
proposed financing alternatives in order to evaluate the status of their ownership
interests. To illustrate, assume that Manning International, Inc. has 500,000 shares of
common stock outstanding and is seeking additional financing to support a $1,500,000
investment at the beginning of the year. The additional financing can be obtained by
either issuing common stock at a price of $15 per share or by issuing 10% bonds with
a $1,500,000 face value. Assume that the earnings before interest and taxes (EBIT) for
the year is $1,220,000 without the impact of the financing. During the year, we assume
that the financing will be invested to earn a 12% pretax return on investment. Which
financing alternative is most beneficial to the stockholders? One consideration is the
impact of financing alternatives on earnings per share. Earnings per share is the net in-
come of the company divided by the outstanding shares during a period. Thus, the
earnings per share is the earnings for each share of stock. Earnings per share is com-
monly used by stockholders to evaluate earnings across different companies, time pe-
riods, and alternatives. We will use earnings per share to evaluate different financing
alternatives in the paragraphs to follow. In the next chapter, we will discuss earnings
per share as it is used to evaluate different companies and time periods.
Exhibit 5 shows the impact on earnings per share for the two financing options
compared to no financing. Both financing options create funds that can be invested to
produce a pretax return of $180,000 ($1,500,000 12%). In the first column, there is no
impact on income except for the before-tax return on investment. That is, the common
stock issuance does not result in any reduction in net income. Taxes are deducted from
the EBIT to obtain a net income of $840,000. Assume the additional 100,000 shares
are issued at a price of $15 per share to obtain the $1,500,000 financing objective. The
earnings per share is thus $1.40 ($840,000 ÷ 600,000 shares). Compared to the third col-
umn, this earnings per share is smaller than the $1.46 ($732,000500,000 shares,
rounded) earnings per share from assuming that the financing was never obtained. The
reduction in earnings per share from issuing more common stock is termed earnings per
share dilution. Shareholders will wish to avoid dilution. Shareholders can avoid dilu-
tion in this case when common stock is issued at a higher price (reducing the number
of shares offered), or the investment earns a higher return on investment. For example,
if the common stock was issued at a price of $50 per share, an additional 30,000 shares
($1,500,000 ÷ $50 per share) would be issued. Under this assumed share price, the504 Chapter 11 Stockholders’ Equity: Capital Stock and Dividends
Analyze the impact
of issuing common stock
or bonds.6
The “Razor Blade” Tactic
HOW BUSINESSES MAKE MONEY
A popular and effective business tactic is to link
a base product to its accessories, often termed the
“razor blade” tactic. Under this approach, the base
product is often sold for a low profit margin, while
the profits are earned on the accessories. The key to
this approach is eliminating competition for the ac-
cessory products by technically or psychologically
linking them to the base product. Examples of thistactic include razors and blades, printers and printer
cartridges, electronic game consoles and games, and
movie tickets and concession items. This is also Mattel,
Inc.’sbusiness strategy for Barbie®. The Barbie doll is
the base product, while all of Barbie’s accessories are
the major source of Mattel’s profitability. The size of
Barbie’s “pink aisle” at the local toy store reveals the
power of Mattel’s razor blade tactic.