Question

Problem #2: Orlando Corporation is preparing the financial statements for the annual report to its shareholders for the fiscal year ended August 31, 2017. The income from operations for fiscal year 2017 was $1,250,000. The company incurred a 6% interest expense on $3,000,000 of debt, an obligation outstanding for the entire fiscal year that requires interest-only payments. The company uses a 40% effective tax rate for income taxes.

The capital structure of Orlando Corporation on September 1, 2016, at the beginning of its fiscal year, consisted of 2 million shares of common stock outstanding and 50,000 shares of $100 par value, 5%, cumulative preferred stock. There were no preferred dividends in arrears, and the company had not issued any convertible securities, options, or warrants.

On December 1, 2016, Orlando sold an additional 400,000 shares of the common stock at $34 per share. Orlando distributed a 10% stock dividend on common shares outstanding on January 1, 2017.

Instructions

1. Identify whether the capital structure at Orlando Corporation is a simple or complex capital structure, and explain why.
2. Determine the weighted-average number of shares that Orlando Corporation would use in calculating earnings per share for the fiscal year ended August 31, 2017.
3. Compute earnings per share.

(CMA adapted)

Answer 1

a)

Orlando Corporation’s capital structure consists of debt, common stock and preferred stock. So it consists of only straight debt and capital obtained from both type of stock. It doesn’t have dilutive securities such as convertible bonds, options, warrants, convertible preferred stock in its capital structure. So capital structure of Orlando Corporation is simple.

b)

Computation of weighted average number of equity shares

*) Adjust the pre dividend number of shares to post dividend number of shares. That is multiplying with 110%. (Stock dividend is 10%)

September 1, 2016 = 2000000 shares * 110 % = 2200000 shares

December 1, 2016 = 400000 shares * 110% = 440000 shares

Months shares are outstanding	Shares outstanding	Fraction of the year outstanding	Equivalent whole units
Sep - Nov	2200000	3/12	550000 shares
Dec - Aug	2640000	9/12	1980000 shares
Weighted average number of common shares outstanding for the year ended August 31, 2017	2530000 shares

c)

Computation of earnings per share

Income from operation = $1250000

Interest on debt = $3000000 * 6% = $180000

Dividend on preferred stock = $100 * 5% * 50000 shares = $ 250000

Earnings before tax = Income from operation - Interest on debt

= $1250000 - $180000 = $ 1070000

Earnings after tax = Earnings before tax – Tax rate = $ 1070000 – 40% = $642000

Earnings available to common shareholders

= Earnings after tax - Dividend on preferred stock

= $642000 - $ 250000 = $ 392000

Earnings per share

= Earnings available to common shareholders /weighted average number of

                                                                             common shares outstanding

        =     $ 392000/ 2530000 shares= $ 0.155 per share