Diluted EPS

[Submariner]

An analyst has put together the following information about B/A Industries
I. Reported N/I of $30,000
II. 5,000 shares of common stock and 2,000 shares of 8%, $90 par preferred stock outstanding for the year
III. During the year, B/A issued at par, $60,000 of 6.0% convertible bonds, each of the 60 bonds convertible into 110 shares of the B/A common stock.
If B/A’s effective tax rate is 40%, what will B/A report for diluted EPS?
Two questions:
a.) why don’t you add the 14400 back to net income?
b.) why do you not add the 2000 shares of preffered into the denominator?
Thanks!

 

[Ernest Seow]

Submariner wrote:
Two questions:
a.) why don’t you add the 14400 back to net income?

The preferred shares are non-convertible, hence you need not add back the preferred dividends of $14,400.

Submariner wrote:
b.) why do you not add the 2000 shares of preffered into the denominator?
Thanks!

This will be in relation to part (a). Since it is not convertible, the weighted average shares used ( i.e. denominator) will not be changed by the preferred shares.
If question states that the preferred shares are convertible, we can use the below to see whether the convertible preferred shares are dilutive:
Preferred dividend / no of converted shares from the convertible preferred share
If the value is < Basic EPS, the convertible prefered shares are dilutive.
Cheers,
Ernest

 

[S2000magician]

EPS means EPCS: Earnings Per Common Share. You put only common shares in the denominator. That’s why we calculate WACSO: Weighted Average Common Shares Outstanding.
I assume that the $14,400 to which you refer is the preferred dividends. That’s money that isn’t available to the common shareholders, so you subtract it from net income. You would add it back only if the preferred stock were convertible into common stock, and then only when you’re doing the fully diluted EPS calculations.

 

[Submariner]

Got it. Thank you, Ernest and S2000.

 

[S2000magician]

My pleasure.
Good luck on Saturday.

 

[Fulcrum]

I believe I already know the answer but just to confirm:
If you have call options that have not been exercised, price is above strike and accounting period is over but no information is mentioned on the expiratin of the options:
Options still need to be included in the dillutive securities for the reported period and they`re assumed as they`ve been exercised, even if they haven`t, company uses the earnings from the common equity sale to cover the options to repurchase a fraction of the equity issued. Am I correct it doesn`t matter whether the options have been exercised or not when we do diluted EPS? I don`t remember seeing this in the CFA curriculum but I found it explained this way in a paper by NY Business school published online.
Thanks!

 

[Submariner]

Thanks for the response. It’s always good to get a multitude of different views on a problem - it helps to understand different ways of solving similar problems!
By the way, what part of Bulgaria are you from? My girlfriend (and my roommate) are from Haskovo…

 

[S2000magician]

Fulcrum wrote:I believe I already know the answer but just to confirm:
If you have call options that have not been exercised, price is above strike and accounting period is over but no information is mentioned on the expiratin of the options:
Options still need to be included in the dillutive securities for the reported period and they`re assumed as they`ve been exercised, even if they haven`t, company uses the earnings from the common equity sale to cover the options to repurchase a fraction of the equity issued. Am I correct it doesn`t matter whether the options have been exercised or not when we do diluted EPS? I don`t remember seeing this in the CFA curriculum but I found it explained this way in a paper by NY Business school published online.
Thanks!

You’re correct: fully diluted EPS is calculated as if common stock has been issued for all dilutive securities (all dilutive options and warrants have been exercised (and treasury stock purchased with the proceeds), and all convertible bonds and preferred stock has been converted).
I wrote an article on this that may be of some help: http://financialexamhelp123.com/earnings-per-share-eps/.

 

[Gebura]

Fulcrum, correct. Only one specification- the average price of the shares for the year should be higher than the exercise price of the option, otherwise it’s not dilutive.

 

[S2000magician]

Gebura wrote:Fulcrum, correct. Only one specification- the average price of the option for the year should be less than the exercise price of the option, otherwise it’s not dilutive.

Unless the company has a net loss during the year. Look at the article I cited above.