Diluted EPS

  • Creator
    Topic
  • #1587707
    Thiscantbelife
    Participant

    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: 100,000

    12/31/7 Convertible preferred: 10,000
    12/31/8 Convertible preferred: 10,000

    12/31/7 9% convertible bonds: 1,000,000
    12/31/8 9% convertible bonds: 1,000,000

    During 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) 2.95

    The 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.

Viewing 3 replies - 1 through 3 (of 3 total)
  • Author
    Replies
  • #1693534
    Popcorn
    Participant

    Did u figure this out? Im trying to figure out that 30000 also

    #1693567
    mskcle
    Participant

    My best guess for this scenario would be that under the IF-CONVERTED method, we assume the securities are converted to common stock at the beginning of the period which would reverse the preferred dividends. I also think we are to assume that they declared them and paid them in the same year which if they are declared, they could be excluded if converted. Hope that makes sense, just my opinion on the question.

    AUD - 83
    BEC - 87
    FAR - 86
    REG - 88
    "You must be really good at math"- Everyone when I say I'm an accountant
    #1693660
    SchruteBeet
    Participant

    The only time we subtract preferred dividends is while calculating the basic EPS. Since we are looking for the diluted EPS here, and are given convertible preferred stock and convertible bond, we use the if-converted method. Under this method, we assume the convertible bond has already been converted into common stock therefore we add the interest saved on the bond net of tax i.e. $63,000 to the numerator and increase the denominator by 30,000 additional shares. Same goes for the convertible preferred stock – we are assuming it has been converted into common stock so we don't take the preferred dividends into consideration (that explains why it was added back) and increase the denominator by 20,000 additional shares. The explanation went from using basic EPS to diluted EPS formula. In order to not get confused, I would just leave the preferred dividends out in the diluted EPS calculation for convertible securities and simply start with the net income. Only use preferred dividends when calculating basic EPS and deciding if the securities are anti-dilutive.

    AUD - 79
    BEC - 80
    FAR - 83
    REG - 78
    Ethics - 97

    "If it were easy, everyone would do it."

    "Hard work, perseverance, faith, blessings."

Viewing 3 replies - 1 through 3 (of 3 total)
  • You must be logged in to reply to this topic.