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An analyst has gathered the following information about Barnstabur, Inc., for the year:

• Reported net income of $30,000.
• 5,000 shares of common stock and 2,000 shares of 8%, $90 par preferred stock outstanding during the whole year.
• During the year, Barnstabur issued at par, $60,000 of 6.0% convertible bonds, with each of the 60 bonds convertible into 110 shares of the Barnstabur common stock.

If Barnstabur’s effective tax rate is 40%, what will Barnstabur report for diluted earnings per share (EPS)?

A) $2.36.

B) $1.66.

C) $1.53.

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Diluted EPS = adjusted earnings after conversion (EAC) / weighted average plus potential common shares outstanding.

Step 1: Calculate Adjusted EAC

adjusted EAC:		net income - preferred dividends
	+	after-tax interest on convertible debt
	=	adjusted earnings available for common shares

preferred dividends = (0.08)(90)(2,000) = 14,400

convertible debt interest = (60,000)(0.06)(1 – 0.40) = 2,160

adjusted EAC = (30,000 – 14,400 + 2,160) = $17,760

Step 2: Calculate Weighted average plus potential common shares outstanding.

weighted average common shares			=	5,000
shares from conversion of convertible bonds	=	(60 × 110)	=	6,600
weighted ave. plus potential common shares outst.			=	11,600

Step 3: Calculate Diluted EPS

Diluted EPS = 17,760 / 11,600 = $1.53.

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Selected information from Baltimore Corp’s financial activities in the year 2004 is as follows:

• Net income was $4,200,000 .

• 750,000 shares of common stock were outstanding on January 1.

• The average market price per share was $50 in 2004.

• Dividends were paid in 2004.

10,000 warrants, which allowed the holder to purchase 10 shares of common stock for each warrant held at a price of $40 per common share, were outstanding the entire year. 

Baltimore’s diluted earnings per share (Diluted EPS) for 2004 is closest to:

A) $5.60.

B) $5.45.

C) $4.94.

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Baltimore’s basic earnings per share (EPS) (net income / weighted average shares outstanding) for 2004 was ($4,200,000 / 750,000 =) $5.60. 

To calculate diluted EPS, we use the treasury stock method to account for the warrants:

• Number of common shares created if options are exercised = 10,000 * 10 = 100,000
• Cash inflow if warrants are exercised = $40 * 100,000 = $4,000,000
• Shares purchased with these funds = $4,000,000/50 = 80,000
• Net increase in shares outstanding = 100,000-80,000 = 20,000

Diluted EPS = $4,200,000/(750,000 + 20,000) = $5.45.

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Quad Associates, Inc.’s net income for 2005 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 2004. Each bond was convertible into 40 shares of common stock. Quad, Inc.’s diluted earnings per share (Diluted EPS) for 2005 was closest to:

A) $2.11.

B) $2.01.

C) $2.23.

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Quad’s basic EPS (net income / weighted average common shares outstanding) was ($892,000 / 400,000 = $2.23.) Diluted EPS is calculated under the assumption that the convertible bonds are converted into common stock as of January 1, 2001, the bond interest net of tax is restored to net income, and the additional common shares are added to the denominator of the equation. Quad’s diluted EPS was (($892,000 + ((2,000 × $1,000 × 0.06)(1 ? 0.40)) / (400,000 + (2,000 × 40)) =) $2.01. Note that since diluted EPS is less than basic EPS, we know that the bonds are dilutive and should be considered in calculating diluted EPS.

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Kendall Company’s net income for 20X4 is $830,000 with 200,000 shares outstanding. Kendall has 1,000 6% convertible bonds (each bond $1,000 face value and convertible into 20 common shares) outstanding for the entire year. Kendall’s tax rate is 40%. What is Kendall Company’s diluted earnings per share for 20X4?

A) $3.77.

B) $4.15.

C) $3.94.

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Kendall’s basic EPS is $830,000 / 200,000 = $4.15. To compute diluted EPS, bond interest paid net of taxes is added to net income, and the number of shares that would be issued in the conversion is added to the denominator. Kendall’s diluted EPS = [$830,000 + (1,000 × $1,000 × 0.06) × (1 – 0.4)] / (200,000 + 20,000) = $3.94. Since diluted EPS is less than basic EPS, we know that the bonds are dilutive and should be considered in calculating diluted EPS.

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Selected information from Caledonia, Inc.’s financial activities in the year 20X6 is as follows:

• Net income = $460,000.
• 2,300,000 shares of common stock were outstanding on January 1.
• The average market price per share was $2 and the year-end stock price was $1.50.
• 1,000 shares of 8%, $1,000 par value preferred shares were outstanding on January 1. Preferred dividends were paid in 20X6.
• 10,000 warrants, each of which allows the holder to purchase 100 shares of common stock at an exercise price of $1.50 per common share, were outstanding the entire year.

Caledonia’s diluted earnings per share for 20X6 are closest to:

A) $0.17.

B) $0.15.

C) $0.13.

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Caledonia’s basic EPS = (net income ? preferred stock dividends) / (weighted average common shares outstanding)
= [$460,000 ? ($1,000 × 1,000 × 0.08)] / 2,300,000 = $0.17.

Using the treasury stock method, if the warrants were exercised, cash inflow would be 10,000 × 100 × $1.50 = $1,500,000. The number of Caledonia shares that could be purchased with the inflow, using the average share price, is $1,500,000 / $2 = 750,000. The net increase in common shares outstanding would have been 1,000,000 ? 750,000 = 250,000.

Diluted EPS = $380,000 / (2,300,000 + 250,000) = $0.15.

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Young Distributors, Inc. issued convertible bonds two years ago, and those bonds are the only potentially dilutive security Young has issued. In 20X5, Young’s basic earnings per share (EPS) and diluted EPS were identical, but in 20X4 they were different. Which of the following factors is least likely to explain the difference between basic and diluted EPS? The:

A) bonds were redeemed by Young Distributors at the beginning of 20X5.

B) bonds were antidilutive in 20X5 but not in 20X4.

C) average market price of Young common stock increased in 20X5.

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Average stock price is not a factor in determining whether convertible bonds are dilutive or antidilutive.

If Young redeemed the bonds, they would have no potentially dilutive securities outstanding in 20X5 and diluted EPS, if the company reported it, would equal basic EPS. Basic and diluted EPS would also be equal in 20X5 if the bonds were antidilutive in that year.

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Nichols Company’s net income for 20X6 was $978,000 with 1,250,000 shares outstanding. The average share price in 20X6 was $8.50. Nichols issued 2,000 warrants to purchase 100 shares each for $10 per share in 20X5. Nichols Company’s diluted earnings per share (diluted EPS) for 20X6 is closest to:

A) $0.777.

B) $0.782.

C) $0.768.

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Nichols basic EPS (net income / weighted average common shares outstanding) was:

$978,000 / 1,250,000 = $0.782.

Because the exercise price of the warrants is higher than the average share price, the warrants are antidilutive and are excluded from diluted EPS. Because there were no other potentially dilutive securities, Nichols' diluted EPS in 20X6 is the same as basic EPS.

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Selected information from Indigo Corp.’s financial activities in the year 20X9 included the following:

• Net income is $5,600,000.
• The tax rate is 40%.
• 500,000 shares of common stock were outstanding on January 1.
• The average market price per share was $82 in 20X9.
• 6,000 5% coupon $1,000 par value convertible bonds, which are convertible at a ratio of 20 shares for each bond, were outstanding the entire year.
• 200,000 shares of common stock were issued on July 1.
• 100,000 shares of common stock were purchased by the company as treasury stock on October 1.

Indigo Corp.’s diluted earnings per share for 20X9 are closest to:

A) $8.32.

B) $9.74.

C) $8.49.

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Indigo’s weighted average common shares = [(500,000 × 12) + (200,000 × 6) – (100,000 × 3)] / 12 = 575,000. Basic EPS = $5,600,000 / 575,000 = $9.74.

For diluted EPS, assume the bonds were converted on January 1, and that interest payments were not made on the bonds. Increasing net income by the amount of bond interest net of tax = $5,600,000 + [6,000 × $1,000 × 0.05 × (1 ? 0.40)] = $5,780,000. Diluted EPS = $5,780,000 / (575,000 + 120,000) = $8.32.

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Selected information from Jupiter Corp.’s financial activities in the year 20X5 is as follows:

• Net income is $18,300,000.
• 115,000 shares of common stock were outstanding on January 1.
• The average market price per share was $150 in 20X5.
• 200 warrants, which each allow the holder to purchase 100 shares of common stock at an exercise price of $100 per common share, were outstanding the entire year.
• 60,000 shares of common stock were issued on April 1.
• 45,000 shares of common stock were purchased by the company as treasury stock on October 1.

Jupiter Corp.’s diluted earnings per share for 20X5 are closest to:

A) $123.02.

B) $113.28.

C) $117.75.

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To compute Jupiter’s basic earnings per share (EPS) use the formula: (net income ? preferred dividends) / weighted average common shares outstanding. Weighted average common shares outstanding = [(115,000 × 12) + (60,000 × 9) – (45,000 × 3)] / 12 = 148,750. Basic EPS = $18,300,000 / 148,750 = $123.02.

Using the treasury stock method, if the warrants were exercised cash inflow would be 200 × $100 × 100 = $2,000,000. The number of Jupiter shares that can be purchased with this cash at the average share price is $2,000,000 / $150 = 13,333. The net number of shares that would have been created is 20,000 ? 13,333 = 6,667. Diluted EPS = $18,300,000 / (148,750 + 6,667) = $117.75. Since diluted EPS is less than basic EPS, the warrants are dilutive.

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Rushford Corp.’s net income is $16,500,000 with 300,000 shares outstanding. The tax rate is 40%. The average share price for the year was $372. Rushford has 50,000, 9%, $1,000 par value convertible bonds outstanding. Each bond is convertible into two shares of common stock.

Rushford Corp.’s basic and diluted earnings per share (EPS) are closest to:

       Basic EPS    Diluted EPS

A) $65.63   $48.00

B) $55.00    $51.56

C) $55.00    $48.00

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Rushford’s basic EPS (net income / weighted average common shares outstanding) is $16,500,000 / 300,000 = $55.00. Diluted EPS is calculated under the assumption that the convertible bonds were converted into common stock, the bond interest net of tax is restored to net income, and the additional common shares are added to the denominator of the equation. Rushford’s diluted EPS is [$16,500,000 + (50,000 × $1,000 × 0.09)(1 - .40)] / (300,000 + (50,000 × 2) = $48.00.