The Ottey Corporation issued 10-year, $4,000,000 par, 7% callable convertible su

Question

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.

Prepare a schedule to compute both basic and diluted earnings per share.

Explanation / Answer

E16-24 (a) (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 straight-line 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. (Round answers for earnings per share to 2 decimal places, e.g. 5.25.) Complete the schedule to compute both basic and diluted earnings per share. Net income for year $ Add: Adjustment for interest (net of tax) * $ *Maturity value $ Stated rate × 7% Cash interest Discount amortization Interest expense Tax rate ×% After tax interest $ Basic Earnings per share $ Diluted Earnings per share $ (a) Net income for year $7,500,000 Add: Adjustment for interest (net of tax) 187,200* $7,687,200 *Maturity value $4,000,000 Stated rate X 7% Cash interest 280,000 Discount amortization [(1.00 – .98) X $4,000,000 X 1/10] 8,000 Interest expense 288,000 1 – tax rate (35%) X .65 After-tax interest $ 187,200 $4,000,000/$1,000 = 4,000 debentures Increase in diluted earnings per share denominator: 4,000 X 18 72,000 Earnings per share: Basic EPS $7,500,000 ÷ 2,000,000 = $3.75 Diluted EPS $7,687,200 ÷ 2,072,000 = $3.71 (b) If the convertible security were preferred stock, basic EPS would be the same assuming there were no preferred dividends declared or the preferred was noncumulative. For diluted EPS, the numerator would be the net income amount of $7,500,000 and the denominator would be 2,072,000. P16-1 (Entries for Various Dilutive Securities) The stockholders' equity section of Martino Inc. at the beginning of the current year appears below. Common stock, $10 par value, authorized 1,000,000 shares, 300,000 shares issued and outstanding $3,000,000 Paid-in capital in excess of par 600,000 Retained earnings 570,000 During the current year the following transactions occurred. The company issued to the stockholders 100,000 rights. Ten rights are needed to buy one share of stock at $32. The rights were void after 30 days. The market price of the stock at this time was $34 per share. The company sold to the public a $200,000, 10% bond issue at $104. The company also issued with each $100 bond one detachable stock purchase warrant, which provided for the purchase of common stock at $30 per share. Shortly after issuance, similar bonds without warrants were selling at 96 and the warrants at $8. All but 5,000 of the rights issued in (1) were exercised in 30 days. At the end of the year, 80% of the warrants in (2) had been exercised, and the remaining were outstanding and in good standing. During the current year, the company granted stock options for 10,000 shares of common stock to company executives. The company using a fair value option pricing model determines that each option is worth $10. The option price is $30. The options were to expire at year-end and were considered compensation for the current year. All but 1,000 shares related to the stock option plan were exercised by year-end. The expiration resulted because one of the executives failed to fulfill an obligation related to the employment contract. Prepare general journal entries for the current year to record the transactions listed above. 1. 2. 3. 4. 5. 6. a)for options exercised and b)for options lapsed Prepare the stockholders' equity section of the balance sheet at the end of the current year. Assume that retained earnings at the end of the current year is $750,000. Stockholders' Equity: Paid-in Capital: Common stock, $10 par value, authorized 1,000,000 shares, 320,100 shares issued and outstanding $ Paid-in capital in excess of par Paid-in capital—Stock warrants $ Retained earnings Total stockholders' equity $ (a) 1. Memorandum entry made to indicate the number of rights issued. 2. Cash 208,000 Discount on Bonds Payable* 8,000 Bonds Payable 200,000 Paid-in Capital—Stock Warrants** 16,000 **Allocated to Bonds: $96 X $208,000 = $192,000; $96 + $8 Discount = $200,000 – $192,000 = $8,000 **Allocated to Warrants: $8 X $208,000 = $16,000 $96 + $8 3. Cash* 304,000 Common Stock (9,500 X $10) 95,000 Paid-in Capital in Excess of Par 209,000 *[(100,000 – 5,000) rights exercised] ÷ *[(10 rights/share) X $32 = $304,000 4. Paid-in Capital—Stock Warrants ($16,000 X 80%) 12,800 Cash* 48,000 Common Stock (1,600 X $10) 16,000 Paid-in Capital in Excess of Par 44,800 *.80 X $200,000/$100 per bond = 1,600 *warrants exercised; 1,600 X $30 = $48,000 5. Compensation Expense* 100,000 Paid-in Capital—Stock Options 100,000 *$10 X 10,000 options = $100,000 6. For options exercised: Cash (9,000 X $30) 270,000 Paid-in Capital—Stock Options (90% X $100,000) 90,000 Common Stock (9,000 X $10) 90,000 Paid-in Capital in Excess of Par 270,000 For options lapsed: Paid-in Capital—Stock Options 10,000 Compensation Expense* 10,000 (b) Stockholders’ Equity: Paid-in Capital: Common Stock, $10 par value, authorized 1,000,000 shares, 320,100 shares issued and outstanding $3,201,000 Paid-in Capital in Excess of Par* 1,123,800 Paid-in Capital—Stock Warrants* 3,200 $4,328,000 Retained Earnings 750,000 Total Stockholders’ Equity $5,078,000 *These two accounts often are combined into one category called Addi¬tional Paid-in Capital, for financial reporting purposes. Calculations: Common Stock Paid-in Capital in Excess of Par At beginning of year 300,000 shares $ 600,000 From stock rights (entry #3) 9,500 shares 209,000 From stock warrants (entry #4) 1,600 shares 44,800 From stock options (entry #6) 9,000 shares 270,000 Total 320,100 shares $1,123,800

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