1215

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

A) potentially dilutive security.

B) non-equity 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.

1215

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

C) Basic EPS can be less than diluted EPS.

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

1215

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) $3.72.

B) $3.28.

C) $2.96.

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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.

1215

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.

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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.

1215

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

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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.