andytrader

Cassie Hamilton is an analyst with Pacers Worldwide, an investment banking firm. She just received the following information (as of year-end) for Trotters Diversified:

• Average common shares outstanding of 5.0 million.
• Average market price for common stock of $35.00 per share.
• Net income of $9.0 million.
• Common stock dividends paid of $1.2 million.
• Preferred dividends paid (on convertible preferred stock noted below) of $1.5 million.
• Tax rate of 40%.
• 500,000 shares of cumulative convertible preferred stock with $30 par value and 10% dividend. Each preferred share is convertible into 5 common shares.
• 10,000 convertible $1,000 par bonds with a 6.0% coupon, each convertible into 8 shares of common stock.
• 400,000 stock options recently issued with an exercise price of $32.00 per share.

In the denominator of the basic EPS calculation, Hamilton should include how many shares related to the convertible bonds?

A) 80,000.

B) 0.

C) 10,000.

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The calculation for basic EPS excludes the impact of complex capital elements.

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Hamilton correctly calculates diluted EPS at approximately:

A) $1.23.

B) $1.50.

C) $1.19.

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As we will show below, only the options and convertible preferred stock are dilutive.First, calculate basic EPS to use as a benchmark to determine dilutive capital components.
Basic EPS = (net income – preferred dividends) / weighted average common shares outstanding
Here, preferred dividends = (0.5 shares × $30 par × 0.10 dividend) = $1.5 million = (9.0 – 1.5) / 5.0 = $1.50.
Now, check for dilutive elements.

• <PTHE options are dilutive because the exercise price is less than the stock price. There is no numerator impact from the options. The denominator impact = # options – [(# options × exercise price) / average stock price)] = 400,000 – [(400,000 × 32) / 35] = 34,286 or 0.034 million.
• To check whether the convertible preferred stock is dilutive we need to determine whether it decreases EPS. To the numerator, we add back the preferred dividend. The denominator impact = (# preferred shares × conversion rate) = 500,000 × 5 = 2,500,000, or 2.5 million. Then, EPS = (9.0 – 1.5 + 1.5) / (5.0 + 2.5) = $1.20. Thus the convertible preferred stock is dilutive.
• 
  To check whether the convertible bonds are dilutive we need to determine whether they decrease EPS. To the numerator, we add back the after-tax impact of the coupon, or (face value × coupon × (1 − t)), or (10,000 bonds × 1,000 par × 0.06 coupon × 0.6 ) = 360,000, or $0.360 million. The denominator impact = (# convertible bonds × conversion rate) = 10,000 × 8 = 80,000, or 0.080 million. Then, EPS = (9.0 – 1.5 + 0.360) / (5.0 + 0.080) = $1.55. Thus the bonds are antidilutive.

Finally, calculate dilutive EPS:
Diluted EPS = (9.0 – 1.5 + 1.5) / (5.0 + 2.5 + 0.034) = approximately $1.19

andytrader

All of the following are considered a potentially dilutive securities EXCEPT:

A) stock options.

B) preferred stock.

C) warrants.

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Not all preferred stock is dilutive. Only convertible preferred stock is potentially dilutive.

andytrader

Examples of potentially dilutive securities include all of the following EXCEPT:

A) non-convertible bonds.

B) convertible preferred stock.

C) options.

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Preferred stock and bonds are only considered to be potentially dilutive if they are convertible. Options are always considered to be potentially dilutive.

andytrader

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

A) antidilutive securities.

B) potentially dilutive securities.

C) derivative securities.

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Dilutive securities are securities that decrease EPS if they are exercised or converted to common stock. When the exercise price is less than the average market price, stock options are considered to be dilutive, Stock options, warrants, convertible debt, and convertible preferred stock are examples of potentially dilutive securities.

andytrader

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.

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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.

andytrader

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) potentially dilutive security.

C) antidilutive security.

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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.

andytrader

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

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

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

C) 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.

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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.

andytrader

Which of the following statements is CORRECT 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.

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

andytrader

Based on the following data, how many shares of common stock should be used to calculate diluted earnings per share?

• Net income of $1,500,000, tax retention rate of 60%
• 1,000,000 shares of common are outstanding at the beginning of the year.
• 10,000, 6% convertible bonds with each bond convertible into 20 shares of common stock were issued at par ($100) on June 30th of this year.
• The firm has 100,000 warrants outstanding all year with an exercise price of $25 per share.
• The average stock price for the period is $20, and the ending stock price is $30.

A) 1,100,000.

B) 1,266,667.

C) 1,000,000.

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First, Check for dilution: Basic EPS = 1,500,000 / 1,000,000 = 1.50
Warrants: anti-dilutive since the average stock price is less than the exercise price
Convertible bonds: numerator impact = (# bonds) × (par value) × (interest rate) × (tax retention rate) × (0.5 for 1/2 year outstanding) = (10,000) × (100) × (0.06) × (0.6) × (0.5) = 18,000, so the numerator = 1,518,000 Denominator impact: increase in average shares = [(# bonds) × (conversion factor) × (# months outstanding)] / 12 = (1,200,000 / 12 = 100,000) so, the denominator = 1,100,000 and EPS with conversion = 1,518,000 / 1,100,000 = 1.38, which is less than 1.50. The bonds are dilutive and the diluted EPS calculation should use 1,100,000 shares of common stock in the denominator. The warrants are out of the money based on the average price of $20.

andytrader

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.

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Doors basic earnings per share (EPS) was ($372,000 / 100,000 =) $3.72. If the bonds were converted, 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.