Diluted EPS Question The Johnson Company is computing diluted earnings per share for the current year The company has convertible bonds outstanding that have been judged as being anti-dilutive What is the significance of anti-dilution? A The bonds must be included in the computation of diluted earnings per share B Because of the high rate of interest on these bonds, the impact must be separately disclosed within the computation C Inclusion of the bonds in the computation must be made using the most conservative method D Inclusion of the bonds in the computation will cause the reported figure to increase so that the potential conversion of the bonds should be excluded The correct answer was D Diluted earnings per share are an attempt to portray a "worse case scenario", the possible impact on earnings per share if all convertible items were to become common stock Some convertibles, though, can actually cause the reported figure to increase Those convertibles are referred to as "anti-dilutive" and are omitted in computing diluted earnings per share so that the worse case scenario can be achieved Question The Pfeiffer Corporation reports net income in the current year of $800,000 Pfeiffer had a nonconvertible preferred stock paying $70,000 in cash dividends Another $2.00 per share in dividends was paid to the common stockholders There are 190,000 shares of this common stock outstanding throughout the year In addition, the company has 20,000 stock options outstanding For $2, each option can be converted into one share of common stock The average price of the stock during the year was $8 The company has an effective tax income rate of 20 percent What is Pfeiffer's diluted earnings per share (rounded)? A $3.48 B $3.56 C $3.68 D $3.76 The correct answer was B Basic earnings per share for this company is $730,000 (net income of $800,000 less the $70,000 in preferred stock dividends) divided by the 190,000 shares of common stock or $3.84 per share (rounded) To convert that figure into diluted earnings per share, the assumption must be made that the stock options are converted into shares of common stock That adds 20,000 shares to the number of common shares However, for this conversion to have occurred, cash of $40,000 ($2 per option times 20,000 options) would have been received That money could have been used by the company in dozens of different ways: buying inventory, funding research and development, paying off interest bearing debt, and the like So that all companies carry out this computation in a similar fashion, the assumption must be made that this money would have been used to buy shares of the company's own stock at its average price for the year Based on this assumption, the company would have acquired 5,000 shares of treasury stock ($40,000 cash divided by an average price of $8 per share) Diluted earnings per share is the $730,000 in income from basic earnings per share divided by 205,000 shares or $3.56 per share (rounded) The 205,000 shares comes from the 190,000 shares outstanding for the year plus the 20,000 shares from the assumed conversion of the stock options less 5,000 shares reacquired using the cash that would have been generated from the stock options Question For Year One, the Seeger Corporation reports net income of $520,000 The company has 10,000 shares of nonconvertible preferred stock outstanding paying $4 per share each year in cumulative dividends The company has 300,000 shares of common stock outstanding throughout the current year In addition, the company issued 9,000 convertible bonds at face value several years ago Each bond has a face value of $100 and is convertible into shares of common stock These bonds pay interest of percent per year The effective income tax rate is 20 percent What is diluted earnings per share (rounded) for Year One? A $1.50 B $1.52 C $1.56 D $1.60 The correct answer was C Basic earnings per share for this company is $480,000 (net income of $520,000 less the $40,000 in preferred stock dividends) divided by the 300,000 shares of common stock or $1.60 per share To convert that figure into diluted earnings per share, the assumption must be made that the convertible bonds are actually converted If that took place, 36,000 shares would be issued (9,000 bonds, each converted into shares of stock) Logically, though, if the bonds had been converted into common stock, no interest expense would have been incurred That interest must be eliminated along with its tax effect With a face value of $900,000 (9,000 bonds having a face value of $100 each) and an interest rate of percent, that interest is $54,000 Eliminating the interest would cause taxable income to rise so that an additional income tax of $10,800 (20 percent rate on the $54,000) is paid Conversion of the bonds causes income to go up $54,000 (to eliminate the interest) and then down $10,800 (to pay the related taxes) Earnings becomes $523,200 ($480,000 plus $54,000 less $10,800) and is divided by 336,000 shares (300,000 plus 36,000 from conversion) for a diluted earnings per share of $1.56 (rounded) Question A company has 200,000 shares of common stock outstanding on January of the current year but issues another 40,000 shares on July In addition, the company has 20,000 shares of preferred stock that pays a $3 per share dividend each year These shares can each be converted into three shares of the company's common stock The company reports net income for the current year of $940,000 It has an effective tax rate of 30 percent What is diluted earnings per share (rounded)? A $3.29 B $3.36 C $3.40 D $3.42 The correct answer was B The company had 200,000 shares of common stock outstanding for the first six months of the year (200,000 times or 1,200,000) and 240,000 outstanding for the final six months (240,000 times or 1,440,000) The weighted average is 220,000 (1,200,000 plus 1,440,000 divided by 12) Basic earnings per share for this company is $880,000 (net income of $940,000 less the $60,000 in preferred stock dividends) divided by this 220,000 average or $4.00 per share To convert that figure into diluted earnings per share, the assumption must be made that the convertible preferred shares are actually turned into common stock The 20,000 shares of preferred stock would become 60,000 shares of common stock In addition, the $60,000 would not be paid There is no tax effect associated with the payment of dividends As a result, diluted earnings per share is $940,000 ($880,000 income from basic earnings per share plus $60,000 in dividends that are eliminated) divided by 280,000 shares of common stock (220,000 plus 60,000 shares from conversion) for a diluted earnings per share of $3.36 (rounded) Question Officials for the Lexington Company are preparing financial statements for Year One The company is reporting net income of $900,000 The company had 100,000 shares of common stock outstanding at the beginning of the year but a stock split on October doubled that number to 200,000 In the previous year, the company issued 10,000 convertible bonds with a face value of $1,000 each that will come due in ten years Each bond is convertible into 15 shares of common stock (adjusted for the stock split) These bonds pay percent interest but were sold for 93 percent of face value to generate a higher interest rate for the buyers The tax rate for the company is assumed to be 30 percent The bond discount is being amortized by the straight-line method What should the company report as its diluted earnings per share (rounded)? A $3.51 B $3.55 C $3.67 D $3.81 The correct answer was A In determining earnings per share, stock dividends and stock splits are assumed to have happened when the computation first began Thus, the stock split is handled here as if it took place on January so that the company had 200,000 shares of common stock outstanding for the entire year Basic earnings per share is $4.50 ($900,000 reported net income divided by these 200,000 shares of common stock) For diluted earnings per share, the bond must be assumed as having been converted Conversion of the 10,000 bonds would require 150,000 shares of common stock to be issued for a total of 350,000 However, interest expense would then have not been recognized The cash interest of $400,000 (4 percent of $10 million face value) plus the $70,000 straight-line amortization of the discount (the $700,000 discount spread evenly over the ten-year life of the bonds) gives interest expense of $470,000 The elimination of that interest (because of the assumed conversion of the bonds) causes net income to go up by $470,000 That increase would also lead to an additional tax expense of $141,000 ($470,000 times 30 percent tax rate) Earnings for this computation is $1,229,000 ($900,000 reported income plus $470,000 interest saved less $141,000 in additional taxes) Thus, diluted earnings per share is $3.51 ($1,229,000 divided by 350,000 shares of common stock) That figure is less than the $4.50 basic earnings per share so the bonds are not antidilutive Question The Pacioli Corporation reports net income for Year One of $800,000 The company had 155,000 shares of common stock outstanding for the entire year as well as 90,000 shares of preferred stock The common stock was paid $1 per share as a dividend while the preferred shareholders received $2 per share The common stock had an average price for the year of $40 per share while the preferred stock had an average price of $60 per share The company also had 20,000 stock options outstanding for the year For $10, each option could be converted into a share of common stock The effective tax rate is 25 percent What should the company report as its diluted earnings per share (rounded) for Year One? A $3.54 B $3.65 C $3.77 D $3.81 The correct answer was B Basic earnings per share must be computed first Net income is $800,000 but the preferred stock receives $180,000 in dividends (90,000 shares times a dividend of $2 per share) That leaves $620,000 in income for the 155,000 shares of common stock for a basic earnings per share of $4.00 To move to diluted earnings per share, the stock options are assumed to be converted into common stock That immediately increases the number of outstanding shares on common stock by 20,000 to 175,000 However, the company receives $10 each or $200,000 in total Some use for that money must be assumed Although in real life, the money might be used in any one dozens of ways, for this computation, the cash that would result from conversion is assumed to be used to buy treasury stock As the common stock has an average price of $40 per share, the $200,000 would enable the company to buy back 5,000 shares as treasury stock ($200,000 divided by $40) Thus, diluted earnings per share is the $620,000 income assigned to common stock divided by the 170,000 shares of common stock (155,000 plus 20,000 converted less 5,000 shares of treasury stock) or $3.65 That figure is less than the basic earnings per share figure so the stock options are not antidilutive Question A corporation has 100,000 shares of common stock outstanding and 20,000 shares of nonconvertible preferred stock A dividend of $1 per share is distributed on the common stock and one of $2 per share is distributed on the preferred stock Net income is $400,000 and the tax rate is 20 percent The corporation also has 10,000 bonds with a face value of $100 and an interest rate of percent Each bond is convertible into two shares of common stock although none have yet been converted The bonds were issued several years ago at face value What is reported as diluted earnings per share (rounded)? A $2.80 B $3.27 C $3.33 D $3.60 The correct answer was B Primary earnings per share must be computed first That is net income ($400,000) less the dividends to preferred stock (20,000 x $2 or $40,000) to arrive at the income ($360,000) that can be assigned to the common stockholders That is then divided by the number of outstanding shares of common stock (100,000) to arrive at primary earnings per share of $3.60 To get to diluted earnings per share, the convertible bond is then assumed to have been converted If converted, 20,000 additional shares would be outstanding (10,000 bonds x shares) If converted, the interest could have been saved ($100 x 4% x 10,000 or $40,000) increasing net income However, that rise in income would also have increased the amount of income tax expense ($40,000 x 20 percent or $8,000) This assumed conversion brings the income assigned to common stock up to $392,000 ($360,000 + $40,000 - $8,000) and the number of shares up to 120,000 so that diluted earnings per shares is $3.27($392,000 divided by 120,000) ... by the 190,000 shares of common stock or $3.84 per share (rounded) To convert that figure into diluted earnings per share, the assumption must be made that the stock options are converted into... acquired 5,000 shares of treasury stock ($40,000 cash divided by an average price of $8 per share) Diluted earnings per share is the $730,000 in income from basic earnings per share divided by 205,000... These bonds pay interest of percent per year The effective income tax rate is 20 percent What is diluted earnings per share (rounded) for Year One? A $1.50 B $1.52 C $1.56 D $1.60 The correct answer