Question

The following information pertains to the Chow Corporation for the fiscal year ended December 31, YR7:

Net Income for YR7                                                                                                   $1,200,000

8% convertible bonds issued at par ($1,000 per bond). Each bond is

convertible into 40 shares of common stock.                                                             $2,000,000

7% convertible bonds issued at par ($1,000 per bond). Each bond is

            convertible into 15 shares of common stock.                                                   $1,500,000

6% convertible, cumulative preferred stock, $100 par value. Each share

            is convertible into 3 shares of common stock.                                       $3,000,000

Common stock, $10 par value                                                                                    $6,000,000

Stock options to purchase 50,000 shares of Common stock at $20 per share (options became fully vested in YR6)                                           

Tax rate for YR7                                         40%

Average market price of common stock during YR7                                                   $25 per share

The 8% convertible bonds were issued on Jan. 1, YR5.

The 7% convertible bonds were issued on Jan. 1, YR4.

The 6% convertible preferred stock was issued on July 1, YR5.

No dividends were declared in YR7. No other preferred stock was outstanding during YR7, other than those shares mentioned above. There were no changes during YR7 in the number of common shares outstanding. There are no shares of treasury stock.

Instructions: Calculate 1) Basic EPS, 2) the marginal effect (ME) on EPS of each potentially dilutive security, and 3) Diluted EPS.

Answer 1

Answer :

(1)

Basic EPS or Simple EPS = NEt income earned - preferred dividend / weighted average number of shares outstanding

YR7 Net income $1,200,000

Common stock @10 par value $6,000,000

No.of shares = $6,000,000/10 = 600,000 shares

YR6 50000 shares in common stock at the end of year 6 = 550,000 shares

Basis EPS = $1200,000 - 0 / 550,000 = $2.18

(2). Marginal effect on each potential dilutive

Weighted average number of shares are outstanding as follows if bonds and preferred shares converted into equity

#		Bond or sl cost	Shares	No of Bonds
Current outstanding shares	5,50,000	-	-	-
8% Convertible bonds	80,000	1 1000	40	$2000,000/1000 = 2000
7% Covrtible bonds	22,500	1 1000	15	$1500,000/1000 = 1500
6% Convertible preferred stock	90,000	1 100	3	$3000,000/100 = 3000
Weighted average number of shares for dilutive securities	7,42,500	-	-	-

Calculation of interest on bonds

8% interest on convertible bonds of value $2,000,000 = $160,000	1,60,000	$160,000 x(1-40%)
7% Interest on convertible bonds of value $1500,000 = $105,000	1,05,000	$105,000 x (1-40%)
Total	2,65,000	-
Tax Rate is 40% what saved when interest expended	1,06,000	-
Total addition to the income	1,59,000	-

Marginal Effect when 8% convertible bonds are converted into common stock

Income increase by $160,000 x (1- 0.40) = $96,000

Number of common stock is increase by 80000

Diluted EPS = ($1200,000 + $96,000) / (550000 + 80000) = 2.05

Marginal effect when 7% convertible bonds are converted into common stock

Income increase by $105,000 x (1-0.40) = $63,000

Number of common stock is increase by 22500

Diluted EPS = ($1200,000 + $63,000)/(550000 + 22500) = $2.21

Marginal effect when preferred shares are converted to common stock

No effect on net income

Number of common stock is increase by 90000

Diluted EPS = ($1200,000) / (550000 + 90000) = $1.88

Status	Common stock	EPS	Me Effect
Common stock	550000	2.18	-
8% Bond converted	630000	$2.05	$0.13
7% Bond converted	652500	$2.21	-$0.03
Prefered converted	640000	$1.88	$0.30

(3).

#		Bond or sl cost	Shares	No of Bonds
Current outstanding shares	5,50,000	-	-	-
8% Convertible bonds	80,000	1 1000	40	$2000,000/1000 = 2000
7% Covrtible bonds	22,500	1 1000	15	$1500,000/1000 = 1500
6% Convertible preferred stock	90,000	1 100	3	$3000,000/100 = 3000
Weighted average number of shares for dilutive securities	7,42,500	-	-	-

Calculation of interest on bonds

8% Interest on convertible bonds of value $2,000,000	1,60,000	$160,000 x (1-40%)
7% Interest on convertible bonds of value $1500,000	1,05,000	$105,000 x (1-40%)
Total	2,65,000	-
Tax Rate is 40% what saved when interest expensed	1,06,000	-
Total additonal to the income	1,59,000	-

Dilute EPS = $1200,000 + $159,000 / 742,500 = $1.83

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