On December 31, 2015, Dow Steel Corporation had 640,000 shares of common stock a
ID: 2775689 • Letter: O
Question
On December 31, 2015, Dow Steel Corporation had 640,000 shares of common stock and 34,000 shares of 8%, noncumulative, nonconvertible preferred stock issued and outstanding. Dow issued a 4% common stock dividend on May 15 and paid cash dividends of $440,000 and $73,000 to common and preferred shareholders, respectively, on December 15, 2016. On February 28, 2016, Dow sold 57,000 common shares. Also, as a part of a 2015 agreement for the acquisition of Merrill Cable Company, another 27,000 shares (already adjusted for the stock dividend) are to be issued to former Merrill shareholders on December 31, 2017, if Merrill's 2017 net income is at least $540,000. In 2016, Merrill's net income was $670,000. In keeping with its long-term share repurchase plan, 6,000 shares were retired on July 1. Dow's net income for the year ended December 31, 2016, was $2,300,000. The income tax rate is 40%. As part of an incentive compensation plan, Dow granted incentive stock options to division managers at December 31 of the current and each of the previous two years. Each option permits its holder to buy one share of common stock at an exercise price equal to market value at the date of grant and can be exercised one year from that date. Information concerning the number of options granted and common share prices follows:
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On July 12, 2014, Dow issued $800,000 of convertible 10% bonds at face value. Each $1,000 bond is convertible into 35 common shares (adjusted for the stock dividend).
Compute Dow's basic and diluted earnings per share for the year ended December 31, 2016.
Date Granted Options Granted Share Price (adjusted for the stock dividend) December 31, 2014 11,000 $ 14 December 31, 2015 6,000 $ 23 December 31, 2016 9,500 $ 22Explanation / Answer
December 31, 2015 Dow's outstanding shares of common stock= 640,000 are outstanding for 12 months in the year
On February 28, 2016, Dow sold 57,000 common shares are outstanding for 10 months in the year,
6,000 shares were retired on July 1,2016 are outstanding for 6 months in the year
weight shares by number of months they were outstanding divided by total months in a year,=>weighted shares remaining outstanding of common stock as of year ended December 31, 2016= 640,000(12/12)+57,000(10/12) - 6,000(6/12) = 640,000+47500-3000= 684500
weighted average number of shares outstanding as of year ended December 31, 2016= 684500
Dow's net income for the year ended December 31, 2016, was $2,300,000.
preferred stock dividends=73,000
Dow's net income for the year ended December 31, 2016 available to common stock holders=Dow's net income-preferred stock dividends= 2,300,000-73,000 = 2227000
Dow's basic earnings per share =Dow's net income for the year ended December 31, 2016 available to common stock holders/weighted average number of shares outstanding as of year ended December 31, 2016
Dow's basic earnings per share =2227000/684500 = $3.25
Convertible Bond interest= 10%*800,000 = 80,000 => after tax Convertible Bond interest=80,000 *(1-40%)=80000*.6=48000
Potential share conversion of Convertible Bond results in additional 35 *(800,000 /1000) shares outstanding = 35 *(800)= 28000 shares
Total options that can be potentially exercised on Dec 2016= Options issued 1 year prior to Dec 2016 as options can be exercised one year from the date of issue. We consider these are American call options .
As options issued on December 31, 2015 are expiring of the money the options would not be exercised thus addition to shares outstanding=0 as exercise price of 23>current share price of 22
Options issued on December 31, 2014 could be exercised(exercise price of 14< share price of 22) on December 31, 2016 ,cash that holder pay for exercising option and buy shares at value 14*11000=154000, shares that can be purchased from market at price 22 from this value on December 31, 2016=154000/22=7000 the remaining 11000-7000=4000 shares are to be issued to pay for options exercised.
Therefore total effect of options exercise on shares outstanding is addition of 4000 shares.
Adjusted Net Income = Dow's net income for the year ended December 31, 2016 available to common stock holders+ after tax Convertible Bond interest= 2227000+48000 = 2275000
Total shares outstanding after dilution from Convertible Bond and options= 684500+ 28000 + 4000 = 716500
Thus diluted earnings per share for the year ended December 31, 2016= Adjusted Net Income after dilution/ weighted average number of shares outstanding as of year ended December 31, 2016 after dilution = 2275000/716500= $3.18
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