GXG CO

Hello John,

GXG Co is considering an issue of $3,200,000 of loan notes paying annual interest of 6%. Investment
of the funds raised would increase operating profit by $576,000 per year.
Recent financial information relating to GXG Co is as follows:
$000
Operating profit 3,450
Interest 200
––––––
Profit before taxation 3,250
Taxation 650
––––––
Profit after taxation 2,600
Dividends 1,600

Which of the following would occur following the loan note issue?
(1) Earnings per share would fall
(2) The cost of equity would rise
(3) Tax shield would rise
A 1, 2 and 3
B 2 and 3 only
C 2 only
D 3 only

1. The answer is B.
2. Why the first statement is incorrect?
– With additional loans, we will need additional interest to pay and therefore earning will decrease. Please advise where I’ve got things wrong?

Thanks