Problem 20 - Accounting

Question

The balance sheet for Bearing Industries Inc. at the end of the current fiscal year indicated the following: $$ \begin{array}{lr} \text { Bonds payable, } 10 \% \text { (issued in 2000, due in 2020) } & \$ 4,000,000 \\ \text { Preferred } \$ 5 \text { stock, } \$ 100 \text { par } & 1,000,000 \\ \text { Common stock, } \$ 10 \text { par } & 2,000,000 \end{array} $$ Income before income tax was \(\$ 1,000,000\), and income taxes were \(\$ 150,000\), for the current year. Cash dividends paid on common stock during the current year totaled \(\$ 200,000\). The common stock was selling for \(\$ 40\) per share at the end of the year. Determine each of the following: (a) number of times bond interest charges are earned, (b) number of times preferred dividends are earned, (c) earnings per share on common stock, (d) price- earnings ratio, (e) dividends per share of common stock, and (f) dividend yield. Round to one decimal place except earnings per share, which should be rounded to two decimal places.

Step-by-Step Solution

Answer

a) 2.5, b) 17.0, c) $4.00, d) 10.0, e) $1.00, f) 2.5%

Step 1: Calculate the Annual Bond Interest

The bonds payable are $4,000,000 with a 10% interest rate. Calculate the annual bond interest using the formula:\[ \text{Annual Bond Interest} = \text{Principal} \times \text{Interest Rate} \]\[ \text{Annual Bond Interest} = 4,000,000 \times 0.10 = 400,000 \]

Step 2: Calculate Net Income

Net income is the income before tax minus income tax. Use the formula:\[ \text{Net Income} = \text{Income Before Tax} - \text{Income Tax} \]\[ \text{Net Income} = 1,000,000 - 150,000 = 850,000 \]

Step 3: Compute Times Interest Earned

The number of times bond interest charges are earned is calculated by dividing income before tax by the annual bond interest:\[ \text{Times Interest Earned} = \frac{\text{Income Before Tax}}{\text{Annual Bond Interest}} \]\[ \text{Times Interest Earned} = \frac{1,000,000}{400,000} = 2.5 \]

Step 4: Calculate Preferred Dividends

The preferred stock is \(1,000,000 at \)100 par with a $5 dividend. Calculate the total annual preferred dividends:\[ \text{Preferred Dividends} = \frac{1,000,000}{100} \times 5 = 50,000 \]

Step 5: Compute Times Preferred Dividends are Earned

This is calculated by dividing net income by preferred dividends:\[ \text{Times Preferred Dividends Earned} = \frac{\text{Net Income}}{\text{Preferred Dividends}} \]\[ \text{Times Preferred Dividends Earned} = \frac{850,000}{50,000} = 17.0 \]

Step 6: Calculate Earnings per Share on Common Stock

Earnings per share (EPS) is computed by dividing (net income minus preferred dividends) by the number of common shares:\[ \text{Number of Common Shares} = \frac{2,000,000}{10} = 200,000 \]\[ \text{EPS} = \frac{850,000 - 50,000}{200,000} = \frac{800,000}{200,000} = 4.00 \]

Step 7: Determine Price-Earnings Ratio

The price-earnings ratio is calculated by dividing the market price per share by earnings per share:\[ \text{Price-Earnings Ratio} = \frac{40}{4.00} = 10.0 \]

Step 8: Calculate Dividends per Share of Common Stock

This is found by dividing the total dividends paid on common stock by the number of common shares:\[ \text{Dividends per Share} = \frac{200,000}{200,000} = 1.00 \]

Step 9: Compute Dividend Yield

The dividend yield is calculated by dividing the dividends per share by the market price per share:\[ \text{Dividend Yield} = \frac{1.00}{40} = 0.025 = 2.5\% \]

Key Concepts

Balance Sheet Analysis

When it comes to understanding a company's financial health, the balance sheet is a vital tool. This financial statement provides a clear picture of what the company owns (assets), what it owes (liabilities), and the shareholders' equity at a given point in time.
For instance, Bearing Industries Inc.'s balance sheet includes liabilities such as bonds payable, indicating a debt of $4,000,000. These bonds were issued with a 10% interest rate. This liability is a key point of focus when analyzing the company's financial obligations.
On the equity side, we see that Bearing Industries has issued preferred stock with a $100 par value and common stock with a $10 par value. Understanding the composition of equity allows stakeholders to comprehend how the company finances its operations and expansion efforts. By dissecting these components, an analyst can interpret the financial stability and capital structure strategy of the company.

Earnings per Share Calculation

Earnings per Share (EPS) is a crucial metric used to gauge a company's profitability relative to its number of outstanding shares. To calculate EPS, you need to know the net income available to common shareholders and the number of common shares outstanding.
For Bearing Industries Inc., once the net income is determined by subtracting income taxes from the income before taxes, preferred dividends are deducted from this net income, as preferred shareholders have priority claims over profits.

• First, calculate the number of common shares: divide the common stock value by its par value.
• Next, find the net income available to common shareholders by subtracting preferred dividends from net income.
• Finally, divide this value by the number of common shares to get the EPS.

In this example, the EPS is $4.00, demonstrating how much profit is attributed to each share of common stock.

Price-Earnings Ratio

The price-earnings (P/E) ratio offers insights into how a company's stock price relates to its earnings. It is pivotal as it helps investors determine if a stock is overvalued, undervalued, or fairly valued. To compute the P/E ratio, divide the current market price per share by the earnings per share (EPS).

• With Bearing Industries, the market price per share is $40 at the end of the year, and the EPS is $4.00.
• The resulting P/E ratio is 10.0, which investors can use as a comparative tool with other companies or industry averages.

A P/E ratio of 10.0 suggests that investors are willing to pay $10 for every $1 earned by the company. Thus, comprehending P/E ratios assists in making informed stock valuation assessments, guiding investment decisions.

Dividend Yield Analysis

Dividend yield is an indicator of how a company's annual dividends compare to its share price. It shows the return a shareholder gains from dividends relative to the stock's price.
In Bearing Industries' case, dividends were paid out at $1.00 per share, and the stock price was $40. To find the dividend yield, simply divide the dividends per share by the market price per share and express it as a percentage.
This gives us a dividend yield of 2.5%.

• A higher yield could suggest that a company is a good income-generating investment, but it could also indicate potential risks if the yield is unusually high due to a falling stock price.
• Conversely, a lower yield might suggest a more stable company with less emphasis on returning income to shareholders.

Therefore, understanding the dividend yield helps investors evaluate the income potential from their investments against other opportunities.