Excel Question E16-22 Eps With Convertible Bonds Various Sit

Excel Question E16 22 Eps With Convertible Bonds Various Situations

In 2013, Chirac Enterprises issued, at par, 60 $1,000, 8% bonds, each convertible into 100 shares of common stock. Chirac had revenues of $17,500 and expenses other than interest and taxes of $8,400 for 2014. (Assume that the tax rate is 40%). Throughout 2014, 2,000 shares of common stock were outstanding; none of the bonds was converted or redeemed. Instructions (a) Compute diluted earnings per share for 2014. (b) Assume the same facts as those assumed for part (a), except that the 60 bonds were issued on September 1, 2014 (rather than in 2013), and none have been converted or redeemed. (c) Assume the same facts as assumed for part (a), except that 20 of the 60 bonds were actually converted on July 1, 2014.

Paper For Above instruction

The calculation of Earnings per Share (EPS) is fundamental in financial analysis, serving as a key indicator of a company's profitability on a per-share basis. When a company has financial instruments like convertible bonds, it is essential to determine the diluted EPS, which accounts for the potential dilution of earnings upon conversion of these instruments into common stock. This paper examines the computation of diluted EPS in various scenarios involving convertible bonds, illustrating the impact of timing, conversion, and outstanding shares on the earnings measure.

Chirac Enterprises, in 2014, faced a typical scenario involving convertible bonds issued in 2013. With bonds totaling $60,000 (60 bonds at $1,000 each) carrying an 8% interest rate, the company needed to analyze its EPS under different assumptions about issuance timing and bond conversions. The company’s earnings before interest and taxes (EBIT) were calculated by subtracting expenses from revenues and then deducting interest expenses for relevant scenarios. The key challenge was accurately adjusting the net income and weighted-average shares outstanding, considering the potential dilution from convertible bonds.

Calculation of Basic Earnings Per Share

Basic EPS is calculated by dividing net income attributable to common shareholders by the weighted-average number of common shares outstanding during the period. For Chirac in 2014:

• Revenues: $17,500
• Expenses other than interest and taxes: $8,400

Interest expense on bonds: 8% of $60,000 = $4,800. The effective interest expense, after considering tax (tax rate 40%), affects net income:

• EBIT: $17,500 - $8,400 = $9,100
• Interest expense (before tax): $4,800
• Tax savings from interest: 40% of $4,800 = $1,920
• Net interest expense after tax: $4,800 - $1,920 = $2,880
• Net income: (EBIT - interest expense after tax) = $9,100 - $2,880 = $6,220

Shares outstanding: 2,000 shares for the entire period; thus, basic EPS is:

Basic EPS = $6,220 / 2,000 = $3.11

Part (a): Diluted EPS with Bonds Issued in 2013 and No Conversions

For diluted EPS, the potential dilutive effect of the convertible bonds must be considered. The bonds are convertible into 100 shares each, so total potential shares from the 60 bonds amount to 6,000 shares. Since none are converted or redeemed, their effect is considered in the calculation.

The assumption is that the bonds are converted at the beginning of the period for dilution purposes. The interest expense saved if bonds are converted is:

• Interest expense: $4,800
• Tax impact: $1,920
• After-tax interest: $2,880

Adjusted net income for diluted EPS calculation is:

Net income + After-tax interest expense if bonds are converted = $6,220 + $2,880 = $9,100

Weighted-average shares outstanding:

• Common shares: 2,000
• Potential shares from conversion: 6,000

Total shares for diluted EPS: 8,000 shares.

Diluted EPS = $9,100 / 8,000 = $1.1375

Part (b): Bonds Issued on September 1, 2014, with No Conversions

The issuance timing affects the weighted-average shares calculation. Since bonds were issued on September 1, 2014, they contribute only four months to the year (September, October, November, December). The weight of these bonds is:

• Weighted-average time: 4/12 = 1/3
• Potential shares: 6,000
• Weighted potential shares: 6,000 × 1/3 = 2,000

The interest expense for these bonds is only relevant if considering their potential conversion, but since none have been converted, the impact on net income is similar to part (a) but adjusted for fewer potential shares.

Part (c): Conversion of 20 Bonds on July 1, 2014

If 20 bonds are converted on July 1, 2014, the calculation of weighted-average shares must reflect the period these conversions took place. The shares from converted bonds are added from July 1 onwards:

• Shares from 40 bonds: 40 × 100 = 4,000 shares for the entire year.
• Shares from 20 bonds: 2,000 shares from July 1 to December 31, 6 months.
• Weighted shares from converted bonds: 2,000 × 0.5 = 1,000

Total shares considering conversions: 2,000 (initial shares) + 4,000 + 1,000 = 7,000

Adjusted net income accounts for the interest saved on bonds converted. The interest expense for the converted bonds (20 bonds) is $1,600 (8% of $20,000). The calculation of net income for this scenario accounts for this saved interest, resulting in a higher net income than in part (a).

Conclusion

The computations demonstrate the significant impact of convertible bonds and their timing on EPS figures. Diluted EPS provides a more comprehensive picture by including all potential dilutive securities. Investors and analysts rely on these calculations to evaluate the company's true earnings performance, especially when potential dilution could materially alter EPS metrics.

References

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