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why might management choose to issue equity instead of borrowing the 1 million is su 621798

Bonus contracts based on income can affect management”s business decisions

The managers of Martin House are paid a salary and share in a bonus that is determined at the end of each year. The total bonus is determined by multiplying the company”s income from operations by 25 percent. The bonus is not considered an operating expense. Interest on borrowed funds is considered an operating expense when computing the bonus.

During 2012, the company decided to expand its plant facility. The estimated cost of the expansion was $1 million. To raise the necessary funds, the company could either borrow $1 million at an annual interest rate of 8 percent or issue 50,000 shares of common stock at $20 each. The company raised the funds using one of these two methods, and income from operations (excluding any interest charges) for 2012 was reported as follows:

Operating revenues

$6,800,000

Operating expense (excluding interest)

5,600,000

Income from operation

$1,200,000

REQUIRED:

a. Assume that on January 1, 2012, Martin House borrowed the $1 million. Compute the total bonus shared by the company”s managers.

b. Assume that on January 1, 2012, Martin House issued common stock to raise the $1 million. Compute the total bonus shared by the company”s managers.

c. Why might management choose to issue equity instead of borrowing the $1 million? Is such a decision necessarily in the best interest of the company”s shareholders?

d. Repeat (a) and (b) above, assuming that the interest expense is not considered an operating expense when computing the bonus.

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