On August 31,2010, Chickasaw Industries issued $25 million of its 30-year, 6% convertible bonds dated August 31, priced to yield 5%. The bonds are convertible at the option of the investors into 1,500,000 shares of Chickasaw's common stock. Chickasaw records interest expense at the effective rate. On August 31,2013, investors in Chickasaw's convertible bonds tendered 20% of the bonds for conversion into common stock that had a market value of $20 per share on the date of the conversion. On January 1,2012, Chickasaw Industries issued $40 million of it 20-year, 7% bonds dated January 1 at a price to yield 8%. On December 31,2013, the bonds were extinguished early through acquisition in the open market by Chickasaw for $40.5 million. Please don't show your work using a financial calculator, but show me how to do this step by step!!
Required: Using the book value method, would recording the conversion of 6% convertible bonds into common stock affect earnings? If so, by how much? Would earnings be affected if the market value method is used? If so, by how much.
Requirement: Were the 7% bonds issued at face value, at a discount, or at premium? Please explain and show your work, and not by showing the results using a financial calculator!!
To determine if recording the conversion of the 6% convertible bonds into common stock affects earnings using the book value method, we need to compare the book value of the bonds being converted with the market value of the common stock issued in exchange.
Step 1: Calculate the book value of the bonds being converted.
Book value = Face value of bonds – Accumulated amortization
Since the bonds were issued at a 5% yield (lower than the coupon rate of 6%), there is a premium. Let's assume the bonds were issued at a premium of $2 million (face value of $25 million - market value of $23 million).
Book value = Face value - Premium = $25 million - $2 million = $23 million
Step 2: Calculate the market value of the common stock issued in exchange.
Market value of common stock = Number of shares issued × Market value per share
The number of shares issued can be calculated by dividing the face value of the bonds by the conversion ratio. In this case, the conversion ratio is 1,500,000 shares per $25 million face value.
Number of shares issued = Face value of bonds ÷ Conversion ratio
= $25 million ÷ 1,500,000
= 16.67 shares
Market value of common stock = Number of shares issued × Market value per share
= 16.67 shares × $20 per share
= $333.33
Since the market value of the common stock ($333.33) is higher than the book value of the bonds being converted ($23 million), there is a gain on conversion.
Step 3: Calculate the impact on earnings.
The gain on conversion is calculated as the difference between the market value of the common stock and the book value of the bonds being converted.
Gain on conversion = Market value of common stock - Book value of bonds being converted
= $333.33 - $23 million
= $310.33
Answer: Recording the conversion of the 6% convertible bonds into common stock using the book value method would affect earnings by a gain of $310.33.
When using the market value method, the impact on earnings would be determined by the difference between the market value of the common stock and the carrying value of the bonds being converted. The carrying value of the bonds is typically the amortized cost on the balance sheet. Since interest expense is recorded at the effective rate, the carrying value of the bonds will have increased over time due to the amortization of the premium.
If the market value of the common stock (in this case, $333.33) is higher than the carrying value of the bonds being converted, there would be a gain on conversion. If the market value is lower, there would be a loss on conversion.
However, without specific information on the carrying value of the bonds, we cannot determine the exact impact on earnings using the market value method.
Regarding the 7% bonds issued at $40 million, we can determine if they were issued at face value, at a discount, or at a premium by comparing the stated rate (coupon rate) with the effective rate (yield rate).
If the stated rate (7%) is equal to the effective rate (8%), the bonds were issued at face value.
If the stated rate is lower than the effective rate, the bonds were issued at a discount.
If the stated rate is higher than the effective rate, the bonds were issued at a premium.
In this case, the effective rate (8%) is higher than the stated rate (7%), indicating that the bonds were issued at a premium.