Problem 20 - Accounting

Question

The balance sheet for Collier Medical, Inc. at the end of the current fiscal year indicated the following: \(\begin{array}{lr}\text { Bonds payable, } 12 \% \text { (issued in 1996, due in 2016) } & \$ 1,500,000 \\ \text { Preferred } \$ 10 \text { stock, } \$ 100 \text { par } & 250,000 \\ \text { Common stock, } \$ 20 \text { par } & 2,500,000\end{array}\) Income before income tax was \(\$ 450,000\), and income taxes were \(\$ 125,000\) for the current year. Cash dividends paid on common stock during the current year totaled \(\$ 100,000\). The common stock was selling for \(\$ 50\) per share at the end of the year. Determine each of the following: (a) number of times bond interest charges were earned, (b) number of times preferred dividends were 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 two digits after the decimal place.

Step-by-Step Solution

Answer

(a) 2.5 times, (b) 10.8 times, (c) $2.4, (d) 20.83, (e) $0.8, (f) 1.6%

Step 1: Calculate Bond Interest Expense

To find the bond interest expense, multiply the bonds payable amount by the interest rate: \[ \text{Interest Expense} = \\(1,500,000 \times 0.12 = \\)180,000 \]

Step 2: Calculate Times Interest Earned

The times interest earned is calculated by dividing the income before income tax by the bond interest expense: \[ \text{Times Interest Earned} = \frac{{\\(450,000}}{{\\)180,000}} = 2.5 \]

Step 3: Calculate Preferred Dividends

The preferred dividends can be obtained by multiplying the preferred stock value by the dividend rate: \[ \text{Preferred Dividends} = \frac{{\\(250,000}}{{\\)100}} \times 10 = \$25,000 \]

Step 4: Calculate Times Preferred Dividends Earned

The times preferred dividends are earned can be found using the following formula:\[ \text{Times Preferred Dividends Earned} = \frac{{\\(450,000 - \text{Interest Expense}}}{{\text{Preferred Dividends}}} = \frac{{\\)450,000 - \\(180,000}}{{\\)25,000}} = 10.8 \]

Step 5: Calculate Net Income

Subtract the income taxes from the income before income tax to find the net income:\[ \text{Net Income} = \\(450,000 - \\)125,000 = \$325,000 \]

Step 6: Calculate Earnings Per Share (EPS) on Common Stock

First, calculate the number of common shares:\[ \text{Number of Common Shares} = \frac{{\\(2,500,000}}{{\\)20}} = 125,000 \]Then, subtract preferred dividends from net income and divide by the number of common shares:\[ \text{EPS} = \frac{{\\(325,000 - \\)25,000}}{{125,000}} = \frac{{\$300,000}}{{125,000}} = 2.4 \]

Step 7: Calculate Price-Earnings Ratio

Divide the market price per share by the earnings per share:\[ \text{Price-Earnings Ratio} = \frac{{\$50}}{{2.4}} = 20.83 \]

Step 8: Calculate Dividends Per Share of Common Stock

Divide the total dividends paid on common stock by the number of common shares:\[ \text{Dividends Per Share} = \frac{{\$100,000}}{{125,000}} = 0.8 \]

Step 9: Calculate Dividend Yield

Divide the dividends per share by the market price per share and multiply by 100 to get a percentage:\[ \text{Dividend Yield} = \frac{{0.8}}{{50}} \times 100 = 1.6\% \]

Key Concepts

Balance Sheet

The balance sheet is a vital financial statement that outlines the financial position of a company at a specific point in time. It provides a snapshot of what the company owns and owes, and the equity held by shareholders. A balance sheet is structured into three main components:

• Assets: These are resources owned by the company that have economic value.
• Liabilities: These are obligations the company needs to fulfill, such as loans or credit from suppliers.
• Equity: This represents the ownership interest held by common and preferred shareholders.

The balance sheet helps investors understand the financial stability of a company, giving insights into how well the company can meet its short-term and long-term obligations.

Earnings Per Share (EPS)

Earnings Per Share, commonly referred to as EPS, is a crucial metric used to assess a company's profitability on a per-share basis. It provides insights into how much money a company makes for each share of its stock, making it a valuable indicator for investors.

To calculate EPS, you'll need to follow these steps:

• First, determine the net income, which is the profit after taxes and preferred dividends are subtracted.
• Next, divide this net income by the total number of outstanding common shares.

The EPS formula looks like this: \[ \text{EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Number of Common Shares}} \]
Earnings Per Share is fundamental in financial analysis, helping investors gauge if a company is generating sufficient profit relative to its number of shares.

Price-Earnings Ratio

The Price-Earnings (P/E) Ratio is an essential tool for investors to evaluate a company's stock price relative to its earnings. It provides an indication of how much investors are willing to pay per dollar of earnings. A high P/E ratio might indicate that a stock's price is high compared to earnings and possibly overvalued, while a lower P/E might suggest the opposite.

To calculate the P/E ratio, you take:

• The current market price per share.
• Divide it by the earnings per share (EPS).

Here is the formula for the Price-Earnings Ratio: \[ \text{P/E Ratio} = \frac{\text{Market Price per Share}}{\text{EPS}} \]
This ratio is a cornerstone of financial analysis as it helps compare the valuation of different companies, which can assist in making informed investment decisions.

Dividend Yield

Dividend Yield is a financial ratio that shows how much a company pays out in dividends each year relative to its stock price. It is an important indicator of the income-generating potential of owning a stock. The higher the dividend yield, the more income you receive from your investment.

To find the dividend yield, follow these steps:

• Determine the dividends per share (DPS), which is the amount paid to shareholders.
• Divide that number by the market price per share.
• Multiply the result by 100 to convert it into a percentage.

The formula for Dividend Yield is: \[ \text{Dividend Yield} = \left(\frac{\text{Dividends per Share}}{\text{Market Price per Share}}\right) \times 100 \]
For investors focused on income, understanding the dividend yield is crucial, as it helps assess the return on investment from dividends alone.