Ottey Corporation issued $4 million of 10-year, 7% callable convertible subordinated debentures on January 2, 2017. The debentures have a face value of $1,000, with interest payable annually. The current conversion ratio is 14:1, and in two years it will increase to 18:1. At the date of issue, the bonds were sold at 98 to yield a 7.2886% effective interest rate. Bond discount is amortized using the effective interest method. Ottey's effective tax was 25%. Net income in 2017 was $7.5 million, and the company had 2 million shares outstanding during the entire year. For simplicity, ignore the requirement to record the debentures' debt and equity components separately.
Instructions
(a) Prepare a schedule to calculate both basic and diluted earnings per share for the year ended December 31, 2017.
(b) Discuss how the schedule would differ if the security were convertible preferred shares.
(c) Assume that Ottey Corporation experienced a substantial loss instead of income for the fiscal year ended December 31, 2017. How would you respond to the argument made by a friend who states: "The interest expense from the conversion of the debentures is not actually saved, and there is no income tax to be paid on the additional income that is assumed to have been created from the conversion of the debentures."