 # Two Schweser Questions

Find two questions in a Schweser practice exam that I don’t quite understand. What do you think should be the answers? -------------- 41. Which of the following statements is FALSE regarding the process by which fiscal policy affects aggregate demand and aggregate supply? The results of restrictive fiscal policy are: A)lower prices and reduced output. B)impossible to predict with respect to prices and output. C)a shift downward and to the right in the aggregate demand curve. D)higher prices and higher output. Answer is D) but I think B), C), D) can all be FALSE… 64. Selected information from Able Company; financial activities in the year 2001 is as follows: Net Income was \$720,000. 1,000,000 shares of common stock were outstanding on January 1. 1,000 shares of eight percent, \$1,000 par value preferred shares were outstanding on January 1 and dividends were paid in 2001. The tax rate was 40 percent. Dividends were paid in 2001. The average market price per share was \$20 in 2001. 6,000 shares of three percent \$500 par value preferred shares, convertible into common shares at a rate of 30 common shares for each preferred share, were outstanding for the entire year. Able; diluted earnings per share (Diluted EPS) for 2001 was closest to: A)\$0.55. B)\$0.65. C)\$0.66. D)\$0.54. Answer is D) but if I add back the preferred dividend, EPS should become 0.588

ymc, “Answer is D) but if I add back the preferred dividend, EPS should become 0.588” what are to adding back to? keep in mind, NI is 720k, which is before the dividend for both classes of preferred shares are deducted, so (the numbers are in 000s), basic = (720-80-90)/1000 = 0.55 convertible = 90/180 = 0.50 -> dilutive, so diluted EPS would be diluted = (720-80)/(1000+180) = 0.54

I think diluted should be (720-80+90*(1-0.4))/1180=0.588 Don’t you need to adjust the income because the convertible preferred stock was converted at the beginning of 2001?

liaaba, could you pls elaboare on your solutions especially for basic part where do you get 80 & 90?

I agree with liaaba. The answer is d) Remember preferred dividends are deducted from NI (which is after-tax). Common EPS = (NI - preferred div)/#commonshares In the problem above there are 2 types of preferred shares 1) 1000 shares, 8%, \$1000 par value = NON-convertible (since not mentioned) 2) 6000 shares, 3%, \$500 par value = Convertible. Hence only 2) needs to be taken care of for the adjustment. No tax adjustment is needed.

But in a similar problem below, I need to add back the tax adjusted dividend to the net income to arrive at the answer d) \$2.01. Why? 46. Quad Associates, Inc.'s net income for 2001 was \$892,000 with 400,000 shares outstanding. The tax rate was 40 percent. Quad had 2,000 six percent \$1,000 par value convertible bonds that were issued in 2000. Each bond was convertible into 40 shares of common stock. Quad, Inc.'s diluted earnings per share (Diluted EPS) for 2001 was closest to: A) \$2.23. B) \$2.41. C) \$2.11. D) \$2.01.

ymc Company has an interest expense of 2000*1000*.06 = 120K When the bonds are converted to shares - company no longer has the interest expense to give up. Hence NI would go up by the (1-T)* tax adjusted amount of the interest expense. Because EBIT - Interest * (1-Tax Rate) = NI. Hence new NI = 892000 + 120000*(1-.4) = 964K # of shares = 400K + 2K * 40 = 480K Hence new EPS = 964/480 = 2.01 Basic EPS = 892 / 400 = 2.23 hence there is a dilution. CP

hari, 80 and 90 are the dividend for the 2 classes of preferred shares ymc, I think you’re confusing preferred shares with debt

cpk123 Wrote: ------------------------------------------------------- > ymc > > Company has an interest expense of 2000*1000*.06 = > 120K > > When the bonds are converted to shares - company > no longer has the interest expense to give up. > Hence NI would go up by the (1-T)* tax adjusted > amount of the interest expense. > > Because (EBIT - Interest) * (1-Tax Rate) = NI. --> Edited this line NI = (EBIT-Interest)*(1-Tax) Forgot the brackets earlier. > > Hence new NI = 892000 + 120000*(1-.4) = 964K > # of shares = 400K + 2K * 40 = 480K > > Hence new EPS = 964/480 = 2.01 > > Basic EPS = 892 / 400 = 2.23 > > hence there is a dilution. > > CP

oic. So you need to adjust net income with convertible bonds but not convertible preferred stock, right?

yup. bond interest is paid out of pre tax income, stock dividends are paid out of net income. so in working out the effect of the convertible bond, you need to work out what the new net income is, without the interest expense above the line.