Chapter 14, Problem 1PB

1.

To determine

Calculate earnings per share of common stock for each plan, if income before bond interest and income tax is $10,000,000.

Explanation of Solution

Bonds: Bonds are long-term promissory notes that are represented by a company while borrowing money from investors to raise fund for financing the operations.

Common stock: It refers to a security issued in a form of certificate and implies the right of ownership of an investor over a portion of company’s earnings and assets.

Earnings per Share: It is a portion of profit that is earned by each common stock.

Formula:

$\text{Earnings per share}\left(\text{EPS}\right)=\frac{\text{Net income }-\text{Preferred dividends}}{\text{ Number of common shares outstanding}}$

Determine Earnings per share of common stock.

Particulars	Plan 1	Plan 2	Plan 3
Net income before interest on bonds and income tax	$10,000,000	$10,000,000	$10,000,000
Less: Interest on bonds	-	-	$3,600,000(1)
Income before income tax	$10,000,000	$10,000,000	$6,400,000
Less: Income tax expense	$4,000,000(2)	$4,000,000(2)	$2,560,000(3)
Net income	$6,000,000	$6,000,000	$3,840,000
Dividends on preferred stock	-	$2,000,000(4)	$1,000,000(5)
Available for dividends on common stock	$6,000,000	$4,000,000	$2,840,000
Number of common stock outstanding	$÷$4,000,000(6)	$÷$2,000,000(7)	$÷$1,000,000(8)
Earnings per share of common stock	$1.50	$2.00	$2.84

Table (1)

Working notes:

(1)

Calculate interest on bonds for plan 3.

$\begin{array}{c}\text{Interest expense}=\text{Face}\text{value}\text{of}\text{bonds}\times \text{}\text{Rate of Interest}\\ \text{= \$40,000,000}\times 9\%\\ =\$3,600,000\end{array}$

(2)

Calculate income tax expense for plan 1 and plan 2.

$\begin{array}{c}\text{Income tax expense}=\left(\begin{array}{l}\text{Income}\text{before}\text{income}\text{tax}\\ \text{×Income}\text{tax}\text{percentage}\end{array}\right)\\ =\$10,000,000\times 40\%\\ =\$4,000,000\end{array}$

(3)

Calculate income tax expense for plan 3.

$\begin{array}{c}\text{Income tax expense}=\left(\begin{array}{l}\text{Income}\text{before}\text{income}\text{tax}\\ \text{×Income}\text{tax}\text{percentage}\end{array}\right)\\ =\$6,400,000\times 40\%\\ =\$2,560,000\end{array}$

(4)

Calculate dividends on preferred stock for plan 2.

$\begin{array}{c}\text{Dividends on preferred stock}=\$40,000,000\times 5\%\\ =\$2,000,000\end{array}$

(5)

Calculate dividends on preferred stock for plan 3.

$\begin{array}{c}\text{Dividends on preferred stock}=\$20,000,000\times 5\%\\ =\$1,000,000\end{array}$

(6)

Calculate Number of common stock outstanding for Plan 1.

$\begin{array}{c}\text{Number of common stock outstanding}=\frac{\$80,000,000}{\$20\text{par}}\\ =4,000,000\end{array}$

(7)

Calculate Number of common stock outstanding for Plan 2.

$\begin{array}{c}\text{Number of common stock outstanding}=\frac{\$40,000,000}{\$20\text{par}}\\ =2,000,000\end{array}$

(8)

Calculate Number of common stock outstanding for Plan 3.

$\begin{array}{c}\text{Number of common stock outstanding}=\frac{\$20,000,000}{\$20\text{par}}\\ =1,000,000\end{array}$

Conclusion

Hence, Earnings per share of common stock for Plan 1, Plan 2, and Plan 3 is $1.50, $2.00 and $2.84 respectively.

2.

To determine

Calculate earnings per share of common stock for each plan, if income before bond interest and income tax is $6,000,000.

Explanation of Solution

Determine Earnings per share of common stock.

Particulars	Plan 1	Plan 2	Plan 3
Net income before interest on bonds and income tax	$6,000,000	$6,000,000	$6,000,000
Less: Interest on bonds	-	-	$3,600,000(1)
Income before income tax	$6,000,000	$6,000,000	$2,400,000
Less: Income tax expense	$2,400,000(9)	$2,400,000(9)	$960,000(10)
Net income	$3,600,000	$3,600,000	$1,440,000
Dividends on preferred stock	-	$2,000,000(4)	$1,000,000(5)
Available for dividends on common stock	$3,600,000	$1,600,000	$440,000
Number of common stock outstanding	$÷$4,000,000(6)	$÷$2,000,000(7)	$÷$1,000,000(8)
Earnings per share of common stock	$0.90	$0.80	$0.44

Table (2)

Working notes:

(9)

Calculate income tax expense for plan 1 and plan 2.

  $\begin{array}{c}\text{Income tax expense}=\left(\begin{array}{l}\text{Income}\text{before}\text{income}\text{tax}\\ \text{×Income}\text{tax}\text{percentage}\end{array}\right)\\ =\$6,000,000\times 40\%\\ =\$240,000\end{array}$

(10)

Calculate income tax expense for plan 3.

  $\begin{array}{c}\text{Income tax expense}=\left(\begin{array}{l}\text{Income}\text{before}\text{income}\text{tax}\\ \text{×Income}\text{tax}\text{percentage}\end{array}\right)\\ =\$2,400,000\times 40\%\\ =\$960,000\end{array}$

Conclusion

Hence, Earnings per share of common stock for Plan 1, Plan 2, and Plan 3 is $0.90, $0.80 and $0.44 respectively.

3.

To determine

Describe the advantages and disadvantages of each plan.

Explanation of Solution

The following are the advantages and disadvantages of Plan 1:

Advantages:

• It involves only in the issuance of common stock. Hence, it does not require to pay periodic interest payment, return on principal, and payment of preferred dividends.
• In case, when earnings before interest and income tax are $6,000,000, Plan 1 is more attractive to common shareholders than Plan 2 and Plan 3 because it has largest EPS ($0.90).

Disadvantage:

• In case, when earnings before interest and income tax are $10,000,000, Plan 1 is less attractive to common shareholders than Plan 2 and Plan 3 because it offers the lowest EPS ($1.50).

The following is the advantages and disadvantages of Plan 2:

Advantage:

• It involves only in the issuance of common stock and preferred stock. Hence, it does not require to pay periodic interest payment, return on principal.
• In both cases, when earnings before interest and income tax is $10,000,000 and $6,000,000, Plan 2 is moderate attractive to common shareholders than Plan 1 and Plan 3 because it provides medium EPS ($2.00) and ($0.80).

Disadvantage:

• In plan 2, it is required to pay preferred dividends before common dividends.

The following is the advantages and disadvantages of Plan 3:

Advantage:

• In case, when earnings before interest and income tax are $10,000,000, Plan 3 is more attractive to common shareholders than Plan 1 and Plan 2 because it offers the largest EPS ($2.84).

Disadvantages:

• In case, when earnings before interest and income tax are $6,000,000, Plan 3 is less attractive to common shareholders than Plan 1 and Plan 2 because it provides lowest EPS ($0.44).
• It involves in the issuance of bonds, common stock and preferred stock. Hence, it is required to pay periodic interest payment, principal payment, and also required to pay preferred dividends before common dividends