honeycfa

When calculating earnings per share (EPS) for firms with complex capital structures, convertible bonds are ordinarily considered to be:

A) embedded debt securities.

B) potentially dilutive securities.

C) antidilutive securities.

---

Dilutive securities are securities that decrease EPS if they are exercised or converted to common stock. Stock options, warrants, convertible debt, and convertible preferred stock are examples of potentially dilutive securities. Note that if diluted EPS when considering the convertible bonds is greater than basic EPS, the convertible bonds would be antidilutive and should not be treated as common stock in computing diluted EPS.

---

honeycfa

When calculating earnings per share (EPS) for firms with complex capital structures, convertible preferred stock is ordinarily considered to be a:

A) non-equity security.

B) antidilutive security.

C) potentially dilutive security.

---

Dilutive securities are securities that decrease EPS if they are exercised or converted to common stock. Stock options, warrants, convertible debt, and convertible preferred stock are examples of potentially dilutive securities. Note that if diluted EPS when considering the convertible preferred stock is greater than basic EPS, the convertible preferred stock would be antidilutive and should not be treated as common stock in computing diluted EPS.

honeycfa

Which of the following statements regarding the treasury stock method of computing diluted shares is least accurate? The treasury stock method:

A) assumes that the hypothetical funds received by the company from the exercise of the options are used to sell shares of the company’s common stock in the market at the average market price.

B) is used when the exercise price of the option is less than the average market price.

C) increases the total number of shares by less than the number that the exercise of the options would create.

---

The treasury stock method assumes any funds received by the company from the exercise of the options are used to purchase shares (not sell shares) of the company’s common stock in the market at the average market price.

honeycfa

Which of the following statements is TRUE regarding the reporting of earnings per share (EPS)?

A) The EPS when antidilutive securities are converted into shares of common stock is less than basic EPS.

B) Basic EPS can be less than diluted EPS.

C) Diluted EPS must be less than or equal to basic EPS.

---

Antidilutive securities are securities that would increase EPS if exercised or converted to common stock.

honeycfa

Selected information from Doors, Inc.’s financial activities in the year 2005 included the following:

• Net income was $372,000.

• 100,000 shares of common stock were outstanding on January 1.

• The average market price per share was $18 in 2005.

• Dividends were paid in 2005.

• 2,000, 6 percent $1,000 par value convertible bonds, which are convertible at a ratio of 25 shares for each bond, were outstanding the entire year.

• Doors, Inc.’s tax rate is 40%.

Doors, Inc.’s diluted earnings per share (Diluted EPS) for 2005 was closest to:

A) $2.96.

B) $3.72.

C) $3.28.

---

Doors basic earnings per share (EPS) was ($372,000 / 100,000 =) $3.72. If the bonds were converted as of January1, interest payments would not have been made. Net income is increased by the interest paid on the bonds net of taxes ($372,000 + (($1000 × 2,000 × 0.06) × (1 ? 0.40)) =) $444,000.

Diluted EPS was ($444,000 / (100,000 + (2,000 × 25)) =) $2.96.

honeycfa

Selected information from Gerrard, Inc.’s financial activities in the most recent year was as follows:

• Net income was $330,000.

• The tax rate was 40%.

• 700,000 shares of common stock were outstanding on January 1.

• The average market price per share for the year was $6.

• Dividends were paid during the year.

• 2,000 shares of 8% $500 par value preferred shares, convertible into common shares at a rate of 200 common shares for each preferred share, were outstanding for the entire year.

• 200,000 shares of common stock were issued on March 1.

Gerrard, Inc.’s diluted earnings per share (diluted EPS) was closest to:

A) $0.197.

B) $0.261.

C) $0.289.

---

To compute Gerrard’s basic earnings per share (EPS) ((net income – preferred dividends) / weighted average common shares outstanding), the weighted average common shares outstanding must be computed. 700,000 shares were outstanding from January 1, and 200,000 shares were issued on March 1, so the weighted average is (700,000 + (200,000 × 10 / 12) =) 866,667. Basic EPS was ($330,000 ? (2,000 × $500 × 0.08)) / 866,667 =) $0.289.

If the convertible preferred shares were converted to common stock as of January 1 (2,000 × 200 =) 400,000 additional common shares would have been issued and dividends on the preferred stock would not have been paid. Diluted EPS was ($330,000 / (866,667 + 400,000) =) $0.261.

honeycfa

Protocol, Inc.’s net income for 2005 was $4,800,000. Protocol had 800,000 shares of common stock outstanding for the entire year. The tax rate was 40 percent. The average share price in 2005 was $37.00. Protocol had 5,000 8 percent $1,000 par value convertible bonds that were issued in 2004. Each bond is convertible into 25 shares of common stock. Protocol, Inc.’s basic and diluted earnings per share for 2005 were closest to:

Basic EPS

Diluted EPS

A) $6.00 $5.45

B) $5.45 $5.19

C) $6.00 $4.92

---

Protocol’s basic EPS (net income / weighted average common shares outstanding) was ($4,800,000 / 800,000 =) $6.00. Diluted EPS is calculated under the assumption that the convertible bonds were converted into common stock as of January 1, 2005, and the bond interest net of tax was restored to net income. The common shares from the conversion of the bonds are added to the denominator of the equation. Protocol’s Diluted EPS was ($4,800,000 + ((5,000 × $1,000 × 0.08)(1 ? 0.40)) / (800,000 + (5000 × 25)) =) $5.45.

honeycfa

Which of the following statements regarding basic and diluted earnings per share (EPS) is most accurate?

A) Neither basic nor diluted EPS considers antidilutive securities in its computation.

B) To calculate diluted EPS, use net income less preferred dividends in the numerator.

C) If diluted EPS is less than basic EPS then the convertible securities are said to be antidilutive.

---

To calculate diluted EPS, dividends on convertible preferred stock and the after tax interest on convertible debt need to be added to net income in the numerator. If diluted EPS are more than basic EPS, the convertible securities are antidilutive and should NOT be used in computing diluted EPS.

honeycfa

Which of the following statements regarding basic and diluted EPS is least accurate?

A) A simple capital structure contains no potentially dilutive securities.

B) Dilutive securities decrease EPS if they are exercised or converted to common stock.

C) Antidilutive securities decrease EPS if they are exercised or converted.

---

Antidilutive securities increase EPS if exercised or converted to common stock.

honeycfa

Orange Company’s net income for 2004 was $7,600,000 with 2,000,000 shares outstanding. The average share price in 2004 was $55. Orange had 10,000 shares of eight percent $1,000 par value convertible preferred stock outstanding since 2003. Each preferred share was convertible into 20 shares of common stock. Orange Company’s diluted earnings per share (Diluted EPS) for 2004 is closest to:

A) $3.80.

B) $3.45.

C) $3.40.

---

Orange’s basic EPS ((net income – preferred dividends) / weighted average common shares outstanding) is ((($7,600,000 ? (10,000 × $1,000 *times; 0.08)) / 2,000,000 =) $3.40. To check for dilution, EPS is calculated under the assumption that the convertible preferred shares are converted into common shares at the beginning of the year. The preferred dividends paid are added back to the numerator of the Diluted EPS equation, and the additional common shares are added to the denominator of the equation. Orange’s if-converted EPS is ($7,600,000 / (2,000,000 + 200,000) =) $3.45. Because if-converted EPS is higher than basic EPS, the preferred stock is antidilutive and no adjustment is made to basic EPS.