Question: The Layton Ball Corporation has a relatively
The Layton Ball Corporation has a relatively complicated capital structure—that is, it raises funds using various financing devices. In addition to common shares, it has issued stock options, warrants, and convertible bonds. Exhibit 17.15 summarizes some pertinent information about these items. Net income for the year is $9,500, and the income tax rate used in computing income tax expense is 40% of pretax income.
a. First, ignore all items of capital except for the common shares. Calculate earnings per common share.
b. In past years, Layton Ball has issued to employees options to purchase shares of stock. Exhibit 17.15 indicates that the price of the common stock throughout the current year has remained steady at $25 but that holders of the stock options could exercise them at any time for $15 for each share. That is, the option allows the holder to surrender it along with $15 cash and receive one share in return. Thus, the number of shares would increase, which would decrease the earnings-per-share figure. The company would, however, have more cash. Assume that the holders of options tender them, along with $15 each, to purchase shares. Assume that the company uses the cash to purchase shares for its own treasury at a price of $25 each. Compute a new earnings-per-share figure. The firm does not count shares in its own treasury in the denominator of the earnings-per share calculation.
c. Exhibit 17.15 indicates that there were also warrants outstanding in the hands of the public. The warrant allows the holder to turn in that warrant, along with $30 cash, to purchase one share of stock. If holders exercised the warrants, the number of outstanding shares would increase, which would reduce earnings per share. However, the company would have more cash, which it could use to purchase shares for the treasury, reducing the number of shares outstanding. Assume that all holders of warrants exercise them. Assume that the company uses the cash to purchase outstanding shares for the treasury. Compute a new earnings-per-share figure. Ignore the information about options and the calculations in part b at this point. Note however that this is an unlikely hypothetical scenario because rational warrant holders would not exercise the warrants for $30 when they can purchase shares for $25 each.
d. The firm also has convertible bonds outstanding. Each convertible bond entitles the holder to exchange that bond for 10 shares. If holders convert the bonds, the number of shares would increase, which would tend to reduce earnings per share. On the other hand, the company would not have to pay interest and thus would have no interest expense on the bond because it would no longer be outstanding. This would tend to increase income and earnings per share. Assume that all holders of convertible bonds convert their bonds into shares. Compute a new net income figure (do not forget income tax effects on income of the interest saved) and a new earnings-per-share figure. Ignore the information about options and warrants and the calculations in parts b and c at this point.
e. Now consider all the previous calculations. Which combined set of assumptions from parts b, c, and d would lead to the lowest possible earnings per share? Compute a new earnings per share under the most restrictive set of assumptions about reductions in earnings per share.
f. Accountants report several earnings-per-share figures for companies with complicated capital structures and complicated events during the year. Financial publications, however, may publish only one figure. Which of the figures computed previously for earnings per share do you think financial publications should publish as the earnings-per-share figure? Why?
Exhibit 17.15
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Layton Ball Corporation Information on Capital Structure for Earnings-per-Share Calculations (Problem 12) EXHIBIT 17.15 Assume the following data about the capital structure and earnings for the Layton Ball Corporation for the year: Number of Common Shares Outstanding Throughout the Year.. 2,500 shares Market Price per Common Share Throughout the Year . $ 25 Options Outstanding During the Year: Number of Shares Issuable on Exercise of Options. . 1,000 shares Exercise Price per Share . $ 15 Warrants Outstanding During the Year: Number of Shares Issuable on Exercise of Warrants.. Exercise Price per Share.... 2,000 shares $ 30 Convertible Bonds Outstanding: Number (Issued 15 Years Ago). Proceeds per Bond at Time of Issue (= Face Value) 100 bonds $1,000 Coupon Rate (Per Year) 4% Cengage Learning 2014
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