BAT4M Learning Activity 4.1
Forks and Spoons Case Study
Forks and Spoons Case Study
Ownership in Forks and Spoons Inc is represented by 300,000 shares of outstanding common
stock on which the corporation has earned an unsatisfactory average of $0.50 per share during
each of the last three years. As a result of the unsatisfactory earnings, the company's
management is planning an expansion that will require the investment of an additional
$3,000,000 in the business. The $3,000,000 is to be acquired either by selling an additional
300,000 shares of the company's common stock at $10 per share or selling bonds at par for
$3,000,000, with an 8% interest rate. Management estimates that the expansion will double the
company's before-tax earnings by an additional 25% over that level in the years that follow.
The company's management wants to finance the expansion in a way that will serve the best
interests of present stockholders, and they have asked you to determine this for them. Complete
the following table, and then give your opinion on which alternative is preferable.
Description
Issue shares
Issue bonds
Income before interest and
1,000,000
1,000,000
Interest expense
0
240,000
Income before income tax
1,000,000
760,000
Income tax expense (30%)
300,000
228,000
Net income
700,000
532,000
Issued shares
600,000
300,000
Earnings per share
1.17
1.77
income tax
Copyright © 2024 The Ontario Educational Communications Authority. All rights reserved.
1
BAT4M Learning Activity 4.1
Forks and Spoons Case Study
Question: Which alternative is better? Explain.
Although both financing options increase earnings, issuing bonds results in a
significantly higher earnings per share (EPS) for the existing shareholders. This is
because no new shares are issued, and the cost of debt (interest) is tax-deductible.
Therefore, the bond option is more favorable for current shareholders as it enhances
their value and avoids dilution of ownership. However, management should also
consider the increased financial risk due to fixed interest obligations. If the company is
confident in its future earnings, debt financing is the better choice.
The following exercise is a chance to practice journalizing the issue of bonds.
On April 1, 2021, Forks and Spoons Inc issued $300,000 of 10-year 10% bonds at face value.
Interest is payable semi-annually, on September 1 and March 1. Prepare the journal entries to
record the following three events.
1. The issue of bonds on April 1, 2021.
Date
Description
Debit
April 1
Cash
300,000
Bonds Payable
Credit
300,000
Issued 10 year 10%
bonds
2. The payment of interest on October 1, assuming interest is not accrued on September
30.
Date
Description
Debit
Oct.1
Interest Expense
15,000
Cash
Credit
15,000
Bonds pay 10% annual interest, which is
$30,000 per year ($300,000 × 10%)
Semi-annual interest = $15,000
Copyright © 2024 The Ontario Educational Communications Authority. All rights reserved.
2
BAT4M Learning Activity 4.1
Forks and Spoons Case Study
3. The accrual of interest on March 31.
Date
Description
Debit
March 31
Interest Expense
2,500
Interest Payable
Credit
2,500
Accruing one
month's interest
Copyright © 2024 The Ontario Educational Communications Authority. All rights reserved.
3