[Anonymous]

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. Cumulative 8%, $50 par preferred stock

B. 10% convertible bonds, issued at par, with each $1,000 bond convertible into 20 shares of common stock

C. 7% convertible bonds, issued at par, with each $1,000 bond convertible into 40 shares of common stock

D. 6%, $100 par cumulative convertible preferred stock, issued at par, with each preferred share convertible into four shares of common stock

C. Dilutive securities reduce earnings per share. To determine dilution, a conversion basis must be stated. Each 7% $1,000 bond yields $49 ($70 – 30% tax) of earnings after tax. The conversion increases the number of shares by 40. The earning per share on the converted bonds is only $1.225 (49/40) thus diluting the basic earnings per share of $1.29.

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Why do you take into account the tax effects when calculating the bond earnings but not the stock earnings?

[Anonymous]

Anyone?

[Anonymous]

Diluted EPS = Income available to common stock shareholder + Interest on dilutive securities / WACS + diluted securities.

Stocks don't earn interest.

[NebCPA]

When looking at diluted EPS, the question being asked is really a “what if” question. In the case of the convertible bonds, the question is what happens to earnings and shares if all of the bonds are converted to stock.

Right now, the company has issued 7% bonds with a $1000 par. This means the company is paying $70 in interest per bond, per year. If all of the bonds are converted, this interest is no longer paid. This means EBT will increase by $70 a year. After-tax, net income will increase $49 ($70 * (1-tax rate)). Since the conversion is for 40 shares, this means earnings per share on the conversion will dilute shares:

$49 additional earnings / 40 additional shares = $1.225 < $1.29 (current)

Your question is a bit oddly worded when you say earnings and may be better understood using the terms interest and dividends. In the case of bonds, we are talking about interest being recouped and with stocks, we are talking about dividends being recouped. The dividends do not flow through the income statement and are not tax deductible. This is why the conversion of preferred stock has no tax effects.

[mdsh_cpa]

If the 7% bonds were converted, interest of $70 per bond would not be paid and, after the 30% tax effect, net income would increase by $49. Each bond would be converted into 40 shares of common stock indicating the equivalent EPS on the conversion is $49/40 or $1.225 per share. Since this is lower than basic EPS, converting the bonds would reduce the amount and be dilutive.

[inviteyou]

If I come across a similar question on test day and find myself short on time, rather than do the calculation do you think it would be ok to guess by the answer choices provided and see that the higher number of shares would increase the denominator? That is adding 40 more shares would have more of an dilutive impact over adding 20?

[Author]

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