dilutive EPS

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  • #1581887
    jessanqi
    Participant

    Hi, the 9% convertible bonds was not included in the dilutive EPS calculation, is that because of this sentence “The 9% convertible bonds are convertible into 30,000 shares of common stock, but are not considered common stock equivalents. ” ??

    Thank you!!!

    Information relating to the capital structure of the Galaxy Company is as follows:

    December 31 December 31

    20X2 20X3
    Outstanding shares of:

    Common stock 90,000 90,000
    Convertible preferred stock 10,000 10,000
    9% convertible bonds $1,000,000 $1,000,000

    During 20X3 Galaxy paid dividends of $2.50 per share on its preferred stock. The preferred stock is convertible into 20,000 shares of common stock and is considered a common stock equivalent. The 9% convertible bonds are convertible into 30,000 shares of common stock, but are not considered common stock equivalents. The net income for the year ended December 31, 20X3, is $485,000. Assume that the income tax rate is 50%.

    What should be the diluted earnings per share, rounded to the nearest penny, for the year ended December 31, 20X3?

    A. $4.41
    B. $3.96
    C. $4.11
    D. $4.51

    Explanation
    The correct answer is A. Diluted earnings per share (EPS) is calculated only for companies that have a complex capital structure with potentially dilutive securities. With a complex capital structure, in addition to having common stock and preferred stock and bonds payable, a company would have potentially dilutive securities such as, convertible preferred stock, convertible bonds payable, stock options and stock warrants, employee stock options, and contingent shares.

    To calculate diluted EPS, all potentially dilutive securities are treated as though the conversion took place, even though it hasn’t. If all the conversions have taken place, there would be an increase in the number of weighted average common outstanding from the conversion. By doing this, it provides the lowest EPS based by assuming all possible common shares have been issued and are outstanding.

    The formula for calculating diluted earnings per share is:

    N = Net income available to common shareholders
    W = Weighted-average number common shares outstanding
    P = Potentially dilutive common shares

    For the numerator, the net income of $485,000

    For the denominator, the weighted average common shares outstanding should include the common stock equivalents from the convertible preferred stock of 20,000 common shares. This would be added to the 90,000 shares of weighted average number of common shares outstanding during the year. The total to be used in the denominator would be 110,000 shares (90,000 + 20,000).

    $485,000 / 110,000 = $4.41

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  • #1581964
    Anonymous
    Inactive

    I think so. The question says the convertible bonds are not considered common stock equivalent. It means the bonds are not potential common shares.

    I would not image this kind of wording for a question in the actual exam. Because it said “The 9% convertible bonds are convertible into 30,000 shares of common stock”. The first half tells they are potential common shares. Then tells you they are not potential common shares. Weird.

    If, just assume the convertible bonds are potential common shares.
    My calculations are:
    basic EPS = (485,000 – 10,000 x 2.5)/90,000 = 460,000/90,000 = 5.11
    The incremental EPS from preferred stock = 2.5 x 10,000/20000 = 1.25. 1.25 < 5.11, the convertible preferred stock has dilutive effect.
    The incremental EPS from convertible bonds = 1,000,000 x 0.09 x (1-50%)/30,000 = 45,000/30,000 = 1.5. 1.5 < 5.11, the convertible bonds have dilutive effect.

    Then calculate the lowest DEPS combination.
    (460,000+25000)/(90,000+20,000)= 4.41
    (460,000+25000+45000)/(90000+20000+30000) = 3.79
    so if the question does not say the bonds are not common stock equivalent, then the DEPS is 3.79.

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