E16-24 (EPS with Convertible Bonds and Preferred Stock) The Ottey Corporation is

Question

E16-24 (EPS with Convertible Bonds and Preferred Stock) The Ottey Corporation issued 10-year, $4,000,000 par, 7% callable convertible subordinated debentures on January 2, 2010. The bonds have a par value of $1,000, with interest payable annually. The current conversion ratio is 14 : 1, and in 2 years it will increase to 18 : 1. At the date of issue, the bonds were sold at 98. Bond discount is amortized on a straightline basis. Ottey’s effective tax was 35%. Net income in 2010 was $7,500,000, and the company had 2,000,000 shares outstanding during the entire year.

Instructions
(a) Prepare a schedule to compute both basic and diluted earnings per share.
(b) Discuss how the schedule would differ if the security was convertible preferred stock.

Explanation / Answer

Basic EPS = (Net Income - Preferred Dividends)/Average Number of Shares Diluted EPS = (Net Income + Interest on Convertible) / (Average Number of Shares + Number of Shares that would be converted) a) Basic: 7,500,000 / 2,000,000 = 3.75 Diluted: Net Income for year 7,500,000 +Adjustment for interest net of tax Cash interest: 4,000,000 * 7% = 280000 Discount Amortization: (1-.98)*4,000,000/10 = 8000 Interest Expense = 288000 Net of Tax = 288000*(1-.35) = 187200 Net Income + Adjustment for interest = $7,687,200 To find shares that would be converted, we use the highest conversion ratio stated (18:1). 4,000 bonds * 18 shares/bond= 72,000 shares Diluted EPS = $7,687,200 / 2,072,000 = 3.71 b) If the security was convertible preferred stock, it would depend if the dividend was declared or cumulative. If it was noncumulative and no preferred dividends were declared, basic EPS would be the same and diluted would be $7,500,000 / 2,072,000 = 3.62. If the dividends were cumulative, you would need to subtract the dividend from the net income in both basic and diluted EPS.

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