Question

1. Officials for the Lexington Company are preparing financial statements for Year One. The company is reporting net income of $900,000. The company had 100,000 shares of common stock outstanding at the beginning of the year but a stock split on October 1 doubled that number to 200,000. In the previous year, the company issued 10,000 convertible bonds with a face value of $1,000 each that will come due in ten years. Each bond is convertible into 15 shares of common stock (adjusted for the stock split). These bonds pay 4 percent interest but were sold for 93 percent of face value to generate a higher interest rate for the buyers. The tax rate for the company is assumed to be 30 percent. The bond discount is being amortized by the straight-line method. What should the company report as its diluted earnings per share (rounded)?

		$3.55
		$3.81
		$3.51
		$3.67

Answer 1

Solution:

In calculation of earnings per share, stock splits and stock dividends are assumed to have happened when the computation first began i.e. at the beginning of year.

Hence, number of common stock shares outstanding for the entire year = 200,000 Shares

So, the basic EPS is as below:

Diluted Earnings Per Share = Adjusted Income / (Weighted Average No of Common Shares outstanding + Potential Diluted Shares)

Each bond is converted into 15 Shares of common stock.

Potential Diluted Shares = 10,000 Bonds * 15 Shares = 150,000 Shares

Weighted Average Number of Common Shares Outstanding = 200,000 Shares

Calculation of Bond Interest Expense

Cash Interest = Face Value 10000 Bonds * 1000 Face Value * 4% Coupon Rate = $400,000

Straight line amortization on Bond Discount = (Total Bond discount 10,000,000 * 7% Discount) / Term on bond 10

= $700,000 / 10

= $70,000

Annual Interest Expense = Cash Interest $400,000 + Amortization of Bond Discount $70,000

= $470,000

Annual Interest Saving = $470,000

Tax on Interest Expense = $470,000 * 30% = $141,000

Diluted Earnings Per Share = (Net Income $900,000 + Interest Saving $470,000 – Additional Tax on saving of Interest $141,000) / (Weighted Average Shares 200,000 + Conversion Share 150,000)

= $1,229,000 / 350,000 Shares

= $3.51

Diluted Earnings Per Share = $3.51

Hence, the correct option is $3.51

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