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Peters Corp.’s capital structure was as follows:
12/31/7 Outstanding shares of common stock: 100,000
12/31/8 Outstanding shares of common stock: 100,00012/31/7 Convertible preferred: 10,000
12/31/8 Convertible preferred: 10,00012/31/7 9% convertible bonds: 1,000,000
12/31/8 9% convertible bonds: 1,000,000During Year 8, Peters paid dividends of $3.00 per share on its preferred stock. The preferred shares are convertible into 20,000 shares of common stock, and the 9% bonds are convertible into 30,000 shares of common stock. Assume that the income tax rate is 30%.
If net income for Year 8 is $350,000, Peters should report DEPS as:a) 2.75
b) 2.92
c) 3.20
d) 2.95The answer is A (2.75). Here is Gleim’s explanation:
Potential common stock is included in the calculation of DEPS if it is dilutive. When two or more issues of potential common stock are outstanding, each issue is considered separately in sequence from the most to the least dilutive. This procedure is necessary because a convertible security may be dilutive on its own but antidilutive when included with other potential common shares in the calculation of DEPS.
The incremental effect on EPS determines the degree of dilution. The lower the incremental effect, the more dilutive. The incremental effect of the convertible preferred stock is $1.50 [($3 preferred dividend × 10,000) ÷ 20,000 potential common shares]. The numerator effect of the conversion of the bonds is $63,000 [$1,000,000 × 9% × (1.0 – .30 tax rate)]. The incremental effect of the convertible debt is $2.10 ($63,000 ÷ 30,000 potential common shares). Because the $1.50 incremental effect of the convertible preferred is lower, it is the more dilutive, and its incremental effect is compared with the BEPS amount, which equals $3.20 [($350,000 – $30,000) ÷ 100,000]. Because $1.50 is lower than $3.20, the convertible preferred is dilutive and is included in a trial calculation of DEPS. The result is $2.92 [($350,000 – $30,000 + $30,000) ÷ (100,000 + 20,000)]. However, the $2.10 incremental effect of the convertible debt is lower than the $2.92 trial calculation, so the convertible debt is also dilutive and should be included in the calculation of DEPS. Thus, the DEPS amount is $2.75 as indicated below.(350-30+30+63)/(100+20+30) = 2.75
I am confused on why the 30,000 was added back in the numerator when it was already paid. Please explain why. Shouldn’t it be [(350-30+63)/150=] 2.55?
Thank you.
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