Question

(EPS with Convertible Bonds and Preferred Stock) The Simon Corporation issued 10-year, $5,000,000par,7$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 straight-line basis. Simon’s effective tax was 35%. Net income in 2017 was $9,500,000, 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

Short answer

1. Basic Earnings Per share $4.75 and Diluted Earnings Per share $4.66
2. In case of basic earnings per sharethere will be no change. In case of Diluted Earnings Per share there will be changes.

Step-by-step solution

Computation of Basic and Diluted Earnings per share-

Net Income for year (A)	$9,500,000
Add: Adjustment for interest (net of tax)	$234,000
Income for diluted earnings per share (B)	$9,734,000
Number of shares for Basic EPS (C)	2,000,000
Add: Shares by conversion (($5,000,000/$1,000) x 18))	90,000
Number of shares for Diluted EPS (D)	2,090,000
Basic Earnings Per share (A / C)	$4.75
Diluted Earnings Per share (B / D)	$4.66

Calculation of after tax interest:

Maturity Value	$5,000,000
Rate	7%
Cash Interest	$350,000
Discount amortization [(1.00-.98) *$5,000,000*1/10]	10,000
Interest expense	$360,000
Tax rate (1-35%)	0.65
After tax interest	$234,000

The schedule would differ if the security was convertible preferred stock-

b. On the off chance that the convertible securities were preferred stock, basic earnings per share would be a similar accepting there were no preferred dividends announced or the preferred was noncumulative. For diluted Earnings per share, the numerator would be the overall net income amount will be $9,500,000 and the denominator would be 2,090,000.