JohnBoy Company had operating income of $500,000 last year. He has two bonds out
ID: 2419467 • Letter: J
Question
JohnBoy Company had operating income of $500,000 last year. He has two bonds outstanding. One bond is a convertible $500,000, 6% interest bond that is due in ix years. The bond is convertible into 30,000 shares of stock. The other bond is a $200,000, 4%, bond that is due in 8 years and that is convertible into 8,000 shares of common stock. JohnBoy has 80,000 shares of stock outstanding and a 30% tax rate. In addition, there are 5,000 options outstanding that can be converted to Lowry's common stock at $12 each.
Calculate JohnBoy's basic and diluted earnings per share. (When calculating the diluted EPS, you must do each bond separately to make sure it is dilutive)
Explanation / Answer
Step - 1) Introduction :
Bond : A debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. The Federal government, states, cities, corporations, and many other types of institutions sell bonds. Generally, a bond is a promise to repay the principal along with interest (coupons) on a specified date (maturity). Some bonds do not pay interest, but all bondsrequire a repayment of principal. When an investor buys a bond, he/she becomes a creditor of the issuer. However, the buyer does not gain any kind of ownership rights to the issuer, unlike in the case of equities.
On the hand, a bond holder has a greater claim on an issuer's income than a shareholder in the case of financial distress (this is true for all creditors). Bonds are often divided into different categories based on tax status, credit quality, issuer type, maturity and secured/unsecured (and there are several other ways to classify bonds as well). U.S. Treasury bonds are generally considered the safest unsecured bonds, since the possibility of the Treasury defaulting on payments is almost zero. The yield from a bond is made up of three components: coupon interest, capital gains and interest on interest (if a bond pays no coupon interest, the only yield will be capital gains). A bond might be sold at above or below par (the amount paid out at maturity), but the market price will approach par value as the bond approaches maturity. A riskier bond has to provide a higher payout to compensate for that additional risk. Some bonds are tax-exempt, and these are typically issued by municipal, county or state governments, whose interest payments are not subject to federal income tax, and sometimes also state or local income tax.
Options : A stock option is the opportunity, granted to you by the issuer (e.g., your company), to purchase a certain number of shares of your company's common stock at a pre-established grant price over a defined period of time.
Outstanding shares: Outstanding shares refer to a company's stock currently held by all its shareholders, including share blocks held by institutional investors and restricted shares owned by the company’s officers and insiders. Outstanding shares are shown on a company’s balance sheet under the heading “Capital Stock.” The number of outstanding shares is used in calculating key metrics such as a company’s market capitalization, as well as its earnings per share (EPS) and cash flow per share (CFPS).
Step - 2) Calculation of JohnBoy's basic earnings per share.
Basic earnings per share is the amount of a company’s profit or loss for a reporting period that is available to the shares of its common stock that are outstanding during the reporting period. It is a useful measure of performance for companies with simplified capital structures.
If a business only has common stock in its capital structure, the company presents only its basic earnings per share for income from continuing operations and net income. This information is reported on its income statement. If there are situations under which more shares might be issued, such as when stock options are outstanding, then diluted earnings per share must also be reported. As the name implies, diluted earnings per share present the lowest possible earnings per share, based on assumptions that all possible shares are issued.
The formula for basic earnings per share is:
Profit or loss attributable to common equity holders of the parent business
number of common shares outstanding during the period
Profit or loss attributable to common equity holders of the parent business = operating income - Interest paid to debt holders (i.e, interest paid to bonds outstanding)
= profit before tax- Income tax expenses
= (500,000 - 500,000 * 6% - 200,000 * 4%) - tax @ 30%
= (500,000 - 30,000 - 8,000)
= 462,000 - 30%
=323,400
number of common shares outstanding during the period = common stock outstnading
= 80,000
Basic earnings per share = 323,400 / 80,000 = $ 4.0425 per share
Step - 3) Calculation of JohnBoy's Diluted earnings per share
Diluted earnings per share is the profit for a reporting period per share of common stock outstanding during that period. The measurement includes the number of shares that would have been outstanding during the period if the company had issued common shares for all potential dilutive common stock outstanding during the period.
The reason for stating diluted earnings per share is so that investors can determine how the earnings per share attributable to them could be reduced if a variety of convertible instruments were to be converted to stock. Thus, this measurement presents the worst case for earnings per share. Earnings per share information only needs to be reported by publicly-held businesses.
If a company has more types of stock than common stock in its capital structure, it must present both basic earnings per share and diluted earnings per share information; this presentation must be for both income from continuing operations and net income. This information is reported on the company’s income statement.
To calculate diluted earnings per share, include the effects of all dilutive potential common shares. This means that you increase the number of shares outstanding by the weighted average number of additional common shares that would have been outstanding if the company had converted all dilutive potential common stock to common stock. This dilution may affect the profit or loss in the numerator of the dilutive earnings per share calculation. The formula is:
(Profit or loss attributable to common equity holders of parent company
+ After-tax interest on convertible debt + Convertible preferred dividends)
(Weighted average number of common shares outstanding during the period
+ All dilutive potential common stock)
You may need to make two adjustments to the numerator of this calculation. They are:
Profit or loss attributable to common equity holders of parent company = 323,400
After-tax interest on convertible debt = (500,000 *6% + 200,000 *4%) - 30% tax rate ( interest paid to bond holders which are convertible into common stock)
=(30,000 + 8,000) - 30%
= 38000 - 30% = 26,600
Weighted average number of common shares outstanding during the period = 80,000 shares
All dilutive potential common stock = 5,000 option outstanding + 30,000 bond one shares + 8,000 bond two shares,they given that they are convertible
= 5,000 + 30,000 + 8,000 = 43,000
Dilutive earnings per share =
(Profit or loss attributable to common equity holders of parent company
+ After-tax interest on convertible debt + Convertible preferred dividends)
(Weighted average number of common shares outstanding during the period
+ All dilutive potential common stock)
=323,400 + 26,600 / 80,000 +43,000
=350,000 / 123,000
Dilutive earnings per share == $ 2.845 per share
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