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Question: . Mae Jong Corp. issues \(1,000,000 of 10% bonds payable which may be converted into 10,000 shares of \)2 par value ordinary shares. The market rate of interest on similar bonds is 12%. Interest is payable annually on December 31, and the bonds were issued for total proceeds of $1,000,000. In accounting for these bonds, Mae Jong Corp. will:

(a) first assign a value to the equity component, then determine the liability component.

(b) assign no value to the equity component since the conversion privilege is not separable from the bond.

(c) first assign a value to the liability component based on the face amount of the bond.

(d) use the “with-and-without” method to value the compound instrument.

Short Answer

Expert verified

Answer

Correct option: d: use the “with-and-without” method to value the compound instrument.

Step by step solution

01

The explanation for the correct option

A convertible bond alludes to a bond that pays a fixed pay and can be converted into stock offers. This change occurs at a specific time with a specific conversion ratio and price value. Whenever a bond is converted into a ratio and a price value, interestingly, the bond cost is a lot higher than the conversion price. For a given situation, the with-and-without technique can be utilized for a valuation of a compound instrument as this strategy is utilized for non-contend arrangements. Therefore, option d is the correct answer.

02

The explanation for the incorrect options

Option a: A liability component is estimated at a fair worth, and afterwards the rest of the returns are designated to an equity component.

Option b: Allocate no worth to an equity component value part since the transformation honour isn't distinguishable from the bond, and is not a method that will be adopted.

Option c: The Mae Jong Corp will not first assign a value to the liability component based on the face amount of the bond.

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Most popular questions from this chapter

Petrenko Corporation has outstanding 2,000 \(1,000 bonds, each convertible into 50 shares of \)10 par value common stock. The bonds are converted on December 31, 2017, when the unamortized discount is \(30,000 and the market price of the stock is \)21 per share. Record the conversion using the book value approach.

Explain how the conversion feature of convertible debt has a value (a) to the issuer and (b) to the purchaser.

Financial Statement Analysis Case

Ragatz, Inc.

Ragatz, Inc., a drug company, reported the following information. The company prepares its financial statements in accordance with GAAP.

2017 (000)

Current liabilities

\(554,114

Convertible subordinated debts

648,020

Total liabilities

1,228,313

Stockholder’s equity

176,413

Net income

58,333

Analysts attempting to compare Ragatz to drug companies that issue debt with detachable warrants may face a challenge due to differences in accounting for convertible debt.

Instructions

(a) Compute the following ratios for Ragatz, Inc. (Assume that year-end balances approximate annual averages.)

(1) Return on assets.

(2) Return on common stock equity.

(3) Debt to assets ratio.

(b) Briefly discuss the operating performance and financial position of Ragatz. Industry averages for these ratios in 2017 were ROA 3.5%; return on equity 16%; and debt to assets 75%. Based on this analysis, would you make an investment in the company’s 5% convertible bonds? Explain.

(c) Assume you want to compare Ragatz to an IFRS company like Merck (which issues nonconvertible debt with detachable warrants). Assuming that the fair value of the equity component of Ragatz’s convertible bonds is \)150,000, how would you adjust the analysis above to make valid comparisons between Ragatz and Merck?

(L04) (EPS: Simple Capital Structure) Ace Company had 200,000 shares of common stock outstanding on December 31, 2018. During the year 2019, the company issued 8,000 shares on May 1 and retired 14,000 shares on October 31. For the year 2019, Ace Company reported net income of \(249,690 after a loss from discontinued operations of \)40,600 (net of tax).

Instructions

What earnings per share data should be reported at the bottom of its income statement?

Pechstein Corporation issued 2,000 shares of \(10 par value common stock upon conversion of 1,000 shares of \)50 par value preferred stock. The preferred stock was originally issued at \(60 per share. The common stock is trading at \)26 per share at the time of conversion. Record the conversion of the preferred stock

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