Question

On June 30, Year 2, Lomond, Inc., issued 20, $10,000, 7% bonds at par. Each bond was convertible into 200 shares of common stock. On January 1, Year 3, 10,000 shares of common stock were outstanding. The bondholders converted all the bonds on July 1, Year 3. The following amounts were reported in Lomond’s income statement for the year ended December 31, Year 3:
Revenues $977,000
Operating expenses (920,000)
Interest on bonds (7,000)
Income before income tax 50,000
Income tax at 30% (15,000)
Net income $ 35,000
What amount should Lomond report as its Year 3 diluted earnings per share (DEPS)?
A. $3.00
B. $2.85
C. $3.50
D. $2.50

Answer 1

Answer:

$2.85

When convertible securities are converted into common stock during the period, it is assumed that they were converted as of the beginning of the earliest period presented for the purpose of computing diluted EPS. If the bonds had been converted at 1/1, the $7,000 in bond interest would not have been incurred. At a 30% tax rate, however, the increase to income would result in an increase to income tax of ($7,000 x 30%) $2,100. As a result, net income attributable to common stockholders would increase by the net of $4,900 to $39,900.

Each of the 20 bonds is convertible into 200 shares of stock. As a result, if they had been converted as of 1/1, there would have been an additional 4,000 shares outstanding for the year, increasing the number outstanding all year to 14,000. Diluted EPS would be ($39,900/14,000) $2.85 per share.

TLDR:

"The bondholders converted all the bonds"

Denominator = 10,000 + 4,000 (1) = 14,000

numerator = 35,000(N/I) + 4,900(2) = 39,900

39,900/14,000 = 2.85

20 x 200= 4,000 (1)

7,000 x .7= 4,900(2)

Explanation: