CASE 6-4 The officers of Environmental, Inc., considered themselves fortunate when the company sold a

$9,000,000 subordinated convertible debenture issue on June 30, Year 1, with a 6% coupon. They had the alternative of refunding and enlarging the outstanding term loan, but the interest cost would have been one-half point above the AA bond rate. The AA bond rate was as high as 81⁄2%

until March 29, Year 1, when it was lowered to 8%, the rate that prevailed until September 21, Year 1, when it was lowered again to 71⁄2%. As of December 31, Year 1, Environmental, Inc., had the following capital structure:

7% term loan* ........................................................................................................ $3,000,000 6% convertible subordinated debentures† .............................................................. 9,000,000 Common stock, $1 par, authorized 2,000,000 shares, issued and outstanding ...... 900,000 900,000 warrants, expiring July 1, Year 6‡ .............................................................. —

Additional Paid-In Capital....................................................................................... 1,800,000 Retained earnings................................................................................................... 4,500,000

*Term loan (originally $5,000,000) is repayable in semiannual installments of $500,000.

†Convertible subordinated debentures, sold June 30, Year 1, are convertible any time at $18 until maturity. Sinking fund of $300,000 per year to start in Year 6.

‡Warrants entitle holder to purchase one share for $10 to expiration on July 1, Year 6.

Additional data for Year 1:

Interest expense ...................................................................................................... $ 500,000 Net income .............................................................................................................. 1,500,000 Dividends paid ........................................................................................................ 135,000 Earnings retained.................................................................................................... 900,000 Market prices December 31, Year 1 (averages for Year 1)

Convertible debentures 6% ................................................................................ $107 Common Stock.................................................................................................... $13 Stock Warrants ................................................................................................... $4.5 Treasury bills interest rate at 12/31/Year 1......................................................... 6%

Required:

a. Calculate and show computations for basic and diluted earnings per share figures for common stock for the Year 1 annual report (assume a 50% tax rate).

b. What is the times-interest-earned ratio for Year 2 assuming net income before interest and taxes is the same as in Year 1 (a 50% income tax rate applies)?