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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) $0.782.

B) $0.777.

C) $0.793.

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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) $9.74.

B) $8.49.

C) $8.32.

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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) $117.75.

C) $159.13.

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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

Dilutied 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.

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Zachary Company’s warrants issued in 2000 are Zachary’s only outstanding potentially dilutive security. In 2005, EPS and Dilutive EPS differed for the first time. A possible explanation for the change is the:

A) average market price of Zachary increased.

B) year-end market price of Zachary increased.

C) average market price of Zachary decreased.

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An increase in average market price could cause Zachary’s warrants to go from antidilutive to dilutive. If the average price of the stock increases during the year, the warrants are likely to be exercised at some point during the year. Neither of the other choices would do this.

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A company has convertible preferred stock outstanding. In the computation of diluted earnings per share, common shares issued when convertible preferred stock is converted are added to the denominator of the basic EPS equation, and the numerator is:

A) adjusted by adding back convertible preferred stock dividends.

B) not adjusted.

C) adjusted by adding back non-convertible preferred stock dividends.

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If convertible preferred stock is dilutive, the preferred dividends that would not have been paid if the preferred stock is converted must be added back to the numerator. Note that any nonconvertible preferred stock dividends are still subtracted from net income in the numerator.

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A 12 percent $100,000 convertible bond was issued on October 1, 2004. It is dilutive and can be converted into 18,000 shares. The effective income tax rate for the year was 40%. What adjustments should be made to calculate diluted earnings per share?

[td=1,1,150]Interest added to the numerator

Shares added to the denominator

A) $3,000 4,500

B) $3,000 18,000

C) $1,800 4,500

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The interest expense for three months net of tax is added to the numerator (12% × $100,000 × 3/12 × 60 %) = $1,800. The number of shares added to the denominator are 4,500. (18,000 × 3 / 12).

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On December 31, 2004, JME Corporation had 350,000 shares of common stock outstanding. On September 1, 2005, an additional 150,000 shares of common stock were issued. In addition, JME had $10 million of 8% convertible bonds outstanding at December 31, 2004, which are convertible into 200,000 shares of common stock. Net income for 2005 was $3 million. Assuming an income tax rate of 40%, what amount should be reported as the diluted earnings per share for 2005?

A) $5.80.

B) $5.00.

C) $6.00.

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If bonds are converted, then net income will increase by 480,000 [10 million × 0.08 × (1 − 0.4)] and shares outstanding will increase by 200,000.
numerator = 3,000,000 + 480,000 = 3,480,000
denominator = 350,000 + (150,000 × 4/12) + 200,000 = 600,000
diluted EPS = 3,480,000 / 600,000 = 5.80

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An analyst has gathered the following information about Zany Corp.

• 
  Net income of $200,000 for the year ended December 31, 2004.
• 
  During 2004, 50,000 common shares were outstanding.
• 
  Zany has 10,000 shares of 7%, $50 par convertible preferred stock outstanding, each convertible into two shares of common.
• 
  5,000 warrants are outstanding with an exercise price of $24. Each warrant is convertible into one common share.
• 
  The average market price per common share during 2004 was $20.

Calculate Zany's basic and diluted earnings per share (EPS) for 2004.

Basic EPS

Diluted EPS

A) $3.30 $2.86

B) $3.30 $2.00

C) $4.00 $2.86

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Basic EPS = (net income − preferred dividends) / number of common shares = (200,000 − 35,000) / 50,000 = $3.30 per share
The preferred shares are converted into 20,000 common shares, the firm does not pay preferred dividends. Diluted EPS = 200,000 / (50,000 + 20,000) = $2.86 per share. The warrants are out of the money at a stock price of $20.

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Assume that the exercise price of an option is $5, and the average market price of the stock is $8. Assuming 816 options are outstanding during the entire year, what is the number of shares to be added to the denominator of the diluted EPS?

A) 510.

B) 306.

C) 816.

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(816)(5) = $4,080. $4,080 / $8 = 510 shares. 816 − 510 = 306 new shares or [(8 − 5) / 8]816 = 306.