Question

Peyton Approved prides itself on transparency with shareholders and investors. The company has added two storefront locations and launched a new marketing campaign, which is estimated to bring in 20,000 new customers over the next 6 months. The company expects this expansion will require an additional $1,000,000 of capital and generate an additional $600,000 of after-tax profit.

The options are: Issuing an additional $1,000,000 of 10%, 100-par convertible preferred stock (same class as is currently outstanding) Issue an additional $1,000,000 of 8% convertible bonds (same terms as the existing issue) $500,000 each of preferred stock and bonds

Determine the impact on earnings per share for each option.

Answer 1

1. Issuing an additional $1,000,000 of 10%, 100-par convertible preferred stock

If preferred stock is issued and is not converted in the year, then 10*1000,000 i.e. $100000 will be paid as preference dividend first out of $600,000. After Tax Profit left equals 600000-100000 = $500,000.

This $500000 will raise the EPS for the year.

However, if shares are converted to Equity shares during the year, this will affect EPS for the year in a positive or negative side. EPS may raise or decline deoending upon the existing equity shares and the number of shares converted.

2. Issue an additional $1,000,000 of 8% convertible bonds

The interest for the year will be 8%*100000 = $80,000. This is the case when no bonds are converted druing the year. Leftover After tax profit = 600000-80000 = $520,000

If no conversion takes place this will be better option than issuing preference shares.

EPS may vary depending upon the conversion taking place or not.

3. $500,000 each of preferred stock and bonds

After Tax profit left to be distributed to Equity shareholders = 600000 - 8%*500000 - 10%*500000

= $510,000

EPS may vary depending upon the conversion taking place or not

Out of the 3 options when no conversion takes place, issuing bonds was a better ption as it had lower rate and higher after tax profit for equity shareholders.