Case: EVALUATING LEVERAGE

Gearing Manufacturing, Inc., is planning a $1,000,000 expansion of its production facilities. The expansion could be financed by the sale of $1,250,000 in 8 percent notes or by the sale of $1,250,000 in capital stock, which would raise the number of shares outstanding from 50,000 to 75,000. Gearing pays income taxes at a rate of 30 percent.

Required:

1. Suppose that income from operations is expected to be $550,000 per year for the duration of the proposed debt issue. Should Gearing finance with notes or stock? Explain your answer.

2. Suppose that income from operations is expected to be $275,000 per year for the duration of the proposed debt issue. Should Gearing finance with notes or stock? Explain your answer.

3. Suppose that income from operations varies from year to year but is expected to be above $300,000, 40 percent of the time and below $300,000, 60 percent of the time. Should Gearing finance with notes or stock? Explain your answer.

4. As an investor, how would you use accounting information to evaluate the risk of excessive use of leverage? What additional information would be useful? Explain.