Convertible Bonds – The Shank Corporation issued $1,500,000 of 10% convertible bonds for $1,620,000 on March 1, 2006. The bonds are dated March 1, 2006, pay interest semiannually on August 31 and February 28, and the premium is amortized using the straight-line method. The bonds are due on February 28, 2016, and each $1,000 bond is convertible into 25 shares of Shank Corporation $10 par common stock. On March 1, 2008, when the shares were selling for $28 per share, $300,000 of bonds were converted. On September 1, 2010, when the shares were selling for $30 per share, the remainder of the bonds were converted.
1. Prepare the journal entries to record each bond conversion using (a) the book value method, and (b) the market value method.
2. If the company were required under GAAP to assign a value to the conversion feature, explain how the valuation would be determined (no calculations are required).
3. Compute the company’s debt-to-equity ratio under each alternative. Assume the company’s other liabilities are $3 million, and that stockholders’ equity before conversion is $3.5 million.