Ignatius Corporation had 7 million shares of common stock outstanding during the current calendar year. It issued ten thousand $1,000, convertible bonds on January 1. Each bond is convertible into 50 shares of common stock. The bonds were issued at face amount and pay interest quarterly at an annual rate of 10%. On June 30, Ignatius issued 100,000 shares of $100 par 6% cumulative preferred stock. Dividends are declared and paid semiannually. Ignatius has an effective tax rate of 40%. Ignatius would report the following EPS data (rounded) on its net income of $20 million:
A)Option a
B)Option b
C)Option c
D)Option d

Question

Ignatius Corporation had 7 million shares of common stock outstanding during the current calendar year. It issued ten thousand $1,000, convertible bonds on January 1. Each bond is convertible into 50 shares of common stock. The bonds were issued at face amount and pay interest quarterly at an annual rate of 10%. On June 30, Ignatius issued 100,000 shares of $100 par 6% cumulative preferred stock. Dividends are declared and paid semiannually. Ignatius has an effective tax rate of 40%. Ignatius would report the following EPS data (rounded) on its net income of $20 million: 
A)Option a 
B)Option b 
C)Option c 
D)Option d

Quizplus · Accepted Answer

To calculate the EPS, we need to adjust the net income for the effects of the convertible bonds and the preferred stock.

First, we need to calculate the interest expense on the convertible bonds. Ignatius issued 10,000 convertible bonds at a face amount of $1,000 each, for a total face amount of $10 million. The annual interest rate is 10%, so the annual interest expense is $1 million ($10 million x 10%). Since the bonds pay interest quarterly, the quarterly interest expense is $250,000 ($1 million / 4). This interest expense is tax deductible, so we need to adjust the net income for the tax savings. The effective tax rate is 40%, so the tax savings is $100,000 ($250,000 x 40%). Therefore, the after-tax interest expense is $150,000 ($250,000 - $100,000).

Next, we need to calculate the dividend on the preferred stock. Ignatius issued 100,000 shares of preferred stock at a par value of $100 per share, for a total par value of $10 million. The annual dividend rate is 6%, so the annual dividend is $600,000 ($10 million x 6%). Since the dividends are paid semiannually, the semiannual dividend is $300,000 ($600,000 / 2). Preferred dividends are paid before common stock dividends, and they are not tax deductible, so we need to adjust the net income for the dividend payment.

Adjusted net income = Net income - After-tax interest expense - Preferred dividends 
Adjusted net income = $20 million - $150,000 - $300,000 
Adjusted net income = $19.55 million

Now we can calculate the EPS:

EPS = (Adjusted net income - Preferred dividends) / Weighted average number of common shares outstanding

To calculate the weighted average number of common shares outstanding, we need to consider the effects of the convertible bonds. Each convertible bond is convertible into 50 shares of common stock, so the potential number of additional common shares is:

Potential number of additional common shares = Number of convertible bonds x Conversion ratio 
Potential number of additional common shares = 10,000 x 50 
Potential number of additional common shares = 500,000

We need to add the potential number of additional common shares to the actual number of common shares outstanding:

Weighted average number of common shares outstanding = Actual number of common shares + Potential number of additional common shares / 2 
Weighted average number of common shares outstanding = 7 million + 500,000 / 2 
Weighted average number of common shares outstanding = 7.25 million

Now we can calculate the EPS:

EPS = ($19.55 million - $300,000) / 7.25 million 
EPS = $2.56

The rounded EPS is $2.56, which corresponds to option B.

Ignatius Corporation Had 7 Million Shares of Common Stock Outstanding