Could someone break this question down for me, I for the life of me just cannot understand how to do this problem the way they are asking it. From Becker F7 HW….
A firm has basic earnings per share of $1.29. If the tax rate is 30%, which of the following securities would be dilutive?
a. Six percent, $100 par cumulative convertible preferred stock, issued at par, with each preferred share convertible into four shares of common stock.
b. Seven percent convertible bonds, issued at par, with each $1,000 bond convertible into 40 shares of common stock.
c. Ten percent convertible bonds, issued at par, with each $1,000 bond convertible into 20 shares of common stock.
d. Cumulative 8%, $50 par preferred stock.
Explanation
Choice “b” is correct. A dilutive security will produce an earnings per share number below basic earnings per share. The formula for basic earnings per share is income available to common shareholders divided by the weighted average number of common shares outstanding. Basic earnings per share is $1.29, and a dilutive security will result in a lower earnings per share number. If the seven percent convertible bonds are converted, the company will save $49 on each bond ($1,000 x .07 x (1 – .30)), but 40 new shares of stock will be issued. This equates to $1.225 per 1 new share, which is a lower ratio than $1.29 per share. So these securities will be dilutive.
Choice “d” is incorrect. There is no indication given that the shares are convertible, so they will not be dilutive.
Choice “c” is incorrect. If the ten percent convertible bonds are converted, the company will save $70 on each bond ($1,000 x .10 x (1 – .30)) and 20 new shares of stock will be issued. This equates to $3.50 per 1 new share, which is a higher ratio than $1.29 per share. So these securities will be anti-dilutive.
Choice “a” is incorrect. If the convertible preferred stock is converted,
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