# Interest is paid annually 31 december the net

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Interest is paid annually 31 December.The net proceeds from the bond issue amounted to \$41 million. The present value of the liability cash flow at the dateof issue was \$32.3 million; the remaining \$8.7 million was allocated to the conversion option. At the date of issuance,the market rate of interest for nonconvertible bonds of similar risk was 9%.On 30 June 20X1, one-quarter of the bonds are converted.The corporation’s income tax rate is 25%.Based on the convertible bond amortization schedule below, the interest expense (using an effective interest rate of 9%)in year 6 on the bonds is \$3,179,918.DateInterest PaidInterest ExpenseAmortizationPrincipal32,298,811Year 12,400,0002,906,893506,89332,805,704Year 22,400,0002,952,513552,51333,358,217
DateInterest PaidInterest ExpenseAmortizationPrincipalYear 32,400,0003,002,240602,24033,960,457Year 42,400,0003,056,441656,44134,616,898Year 52,400,0003,115,521715,52135,332,419Year 62,400,0003,179,918779,91836,112,337Year 72,400,0003,250,110850,11036,962,447Year 82,400,0003,326,620926,62037,889,067Year 92,400,0003,410,0161,010,01638,899,083Year 102,400,0003,500,9171,100,91740,000,000The conversion of \$10,000,000 principal amount of bonds results in an additional 20,000 shares issued. In the basic EPScalculation, the additional shares are outstanding for the second half of the year and are weighted proportionately in thedenominator. On conversion, the amount of interest for year 6 would have been (based on the above schedule):1 January to 30 June: \$3,179,918 × 6/12 × 40/40 =\$1,589,9591 July to 31 December: \$3,179,918 × 6/12 × 30/40 =\$1,192,469Total interest expense\$2,782,428The EPS numerator already includes, in earnings, a deduction for (pretax) interest of \$1,589,959 on \$40,000,000 for thefirst half of the year. After the conversion, the interest for the second half of the year will be an interest expense of\$1,192,469 (\$1,589,959×30/40) on the remaining \$30,000,000 for the second half of the year following conversion. Thecalculation of basic EPS is shown at the top of Exhibit 20-6.EXHIBIT 20-­‐6BASIC AND DILUTED EPS CALCULATIONS
To calculate diluted EPS, the conversion must be backdated to the beginning of the year (step 6). The effect of theremaining unconverted bonds must be included (step 9). Both of these adjustments are madeonly if dilutive.For backdating, the EPS numerator must be reduced by the six months’ interest actually expensed on the \$10,000,000principal amount of converted bonds. At a 25% income tax rate, the first six-months’ interest on the converted bonds was:Interest expense after-tax = 1,589,959×10/40×(1.00.25) = 298,117In general, the formula for computing the interest savings from conversion is:Interest expense for the period×fraction of yearbeforeconversion×(1 – tax rate)For example, if the bonds had been retired after four months of the fiscal year, four months of interest would be addedback.The highlighted section of Exhibit 20-6 shows the add-back of \$298,117 after-tax interest expense, and the weighted-average number of shares is increased to reflect the full amount of shares issued on conversion. Shares are calculated as20,000 shares×6/12. The EPSindividual effectis \$29.81 (i.e., \$298,117 ÷ 10,000), which is dilutive, relative to basic EPSof \$50.

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Term
Winter
Professor
LizFarrel
Tags
Test, Generally Accepted Accounting Principles