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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)
$0.289.
B)
$0.261.
C)
$0.197.



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, 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.

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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 EPSDiluted EPS
A)
$6.00$4.92
B)
$6.00$5.45
C)
$5.19$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, 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 + (5,000 × 25)] = $5.45.

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Which of the following statements regarding basic and diluted earnings per share (EPS) is most accurate?
A)
Diluted EPS does not include 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.

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Which of the following statements regarding basic and diluted EPS is least accurate?
A)
Antidilutive securities decrease EPS if they are exercised or converted.
B)
A simple capital structure contains no potentially dilutive securities.
C)
Dilutive securities decrease EPS if they are exercised or converted to common stock.



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

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The primary difference between basic EPS and diluted EPS is that:
A)
diluted EPS includes the potential effects of convertible securities while basic EPS does not.
B)
proprietors and partners report basic EPS but corporations report diluted EPS.
C)
extraordinary items and discontinued operations are omitted from basic EPS but included in diluted EPS.


The primary difference between basic EPS and diluted EPS is that diluted EPS includes the potential effects of convertible securities while basic EPS does not.

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Advantage Corp.'s capital structure was as follows:
December 31, 2005December 31, 2004
Outstanding shares of stock:
Common110,000110,000
Convertible Preferred10,00010,000
8% Convertible Bonds$1,000,000$1,000,000

During 2005, Advantage paid dividends of $3 per share on its preferred stock. The preferred shares are convertible into 20,000 shares of common stock. The 8% bonds are convertible into 30,000 shares of common stock. Net income for 2005 was $850,000. Assume the income tax rate is 30%.
Calculate Advantage's basic and diluted earnings per share (EPS) for 2005.
Basic EPSDiluted EPS
A)
$7.45$5.66
B)
$6.31$5.66
C)
$7.45$6.26



Basic EPS = net income − pref div / wt. ave. shares of common
[850,00 − (3 × 10,000)] / 110,000 = $7.45
Diluted EPS = [(net income − preferred dividends) + convertible preferred dividends + (convertible debt interest)(1 − t)] / [(weighted average shares) + (shares from conversion of conv. pfd shares) + (shares from conversion of conv. debt) + (shares issuable from stock options)]
[(850,000 − (3 × 10,000)) + 30,000 + (80,000)(1 − 0.3)] / [(110,000) + (20,000) + (30,000)] = $5.66.

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Securities that would decrease earnings per share (EPS) if they were exercised and converted to common stock are called:
A)
dilutive securities.
B)
synthetic 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 dilutive securities.

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Securities that improve basic per share earnings, or reduce per share losses, if they are exercised or converted to common stock are called:
A)
antidilutive securities.
B)
dilutive securities.
C)
embedded securities.



Antidilutive securities, upon exercise, increase basic EPS or decrease per share losses. Shares from conversion are not included in the calculation of basic or diluted EPS.

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Which of the following statements about the earnings per share calculation are most accurate?
A)
When calculating diluted EPS you must add the shares created from the conversion of the bonds to the denominator and the interest expense times the tax rate to the numerator.
B)
None of these choices are correct.
C)
If the diluted EPS is less than the basic EPS, then the diluted EPS is said to be anti-dilutive.



Anti-dilutive is when dilutive EPS > basic EPS. When calculating diluted EPS, you must add the shares created from the conversion of the bonds to the denominator and the interest (1 – tax rate) to the numerator.

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Anti-dilutive securities should:
A)
not be used in calculating basic or diluted EPS.
B)
be used in calculating basic EPS but not diluted EPS.
C)
be used in calculating diluted EPS but not basic EPS.



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

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