Earnings Per Share (EPS) : RCJ Chapter 15 (836-842)

 

Earnings Per Share (EPS) RCJ Chapter 15

(836-842)

 

Key Issues Basic EPS Weighted average common shares Pecking order Treasury stock transactions Dilution Diluted EPS

1. 2. 3. 4. 5. 6. 7.

options and bonds warrants: method Convertible and treasury preferredstock stock: if converted method Determining dilution vs anti-dilution

8.

9.

 

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Basic EPS Basic EPS   

 

 Net income - Preferred dividends Weighted average number of  common stock outstanding

weight shares outstanding by fraction of year; changes due to share repos, issuances, option exercises, etc..

 

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Basic EPS - Example 

On January 1, 2001 Solomon Corporation had: 160,000 common shares outstanding. 10,000 preferred shares, $100 par value, 7%

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On September 1, 2001 the company issued 40,000 additional common shares. The net income for 2001: $1,257,331 What is the basic EPS? Preferred dividends = 10,000 x 100 x0.07 = $70,000 (a) Shares (b) Portion Weighted shares Time span outstanding of year  (col. a x col. b) Jan 1 - Aug 31   160,000 2// 3 2   106,667 S ep1 - Dec 31   200,000 1/ 3 1/   66,667

 

Basic EPS

$1,257,331 - $70,000 

 

  

173,333

$6.85 per share

4

173,334 shares  

Basic EPS (cont’d) EPS is from common shareholders shareholders’’ viewpoint Pecking order of suppliers of capital: Debt holders 1. Preferred stock holders 2. Common stock holders 3. Why are preferred dividends subtracted, but not bond interest?



Ex. E15-14; P15-4

 

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Effect of Treasury Stock Transactions  1. Purchase of treasury shares:  shares:  DR Tr Trea easu sury ry st stoc ock k ((co cont ntra ra O/ O/E EA A/C /C)) CR Cash

shares:  2. resale of treasury shares:  DR  Cash DR   APC CR  CR 

or

Treasury stock (at cost, from 1.)  APC

DR (or CR) to APC is economic econo mic loss (or gain) that is not recognized in accounting

 

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Effect of Treasury Stock Transactions (cont’d) Key point: Transactions in own common stock don’t affect NI (proprietary viewpoint), only affect number of shares outstanding; so firms can manipulate EPS Q: Q:How How does transaction timing during the year affect EPS? Ex. E15-16; P15-8

 

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Diluted EPS 

SFAS No. 128 requires companies with complex capital structures to compute another measure called diluted earnings per share.

Diluted EPS =

Income adjustments due to Net income - Preferred dividends + dilutive financial instruments Weighted average number of

+

Newly issuable shares due to dilutive financial instruments

common shares outstanding 

(1) Options; and (2) Convertible securities can: Only dilutive securities  Decrease EPS  dilutive 

 

Increase EPS

 anti-dilutive  anti-dilutive   Paul Zarowin

are included in the diluted EPS calculation 8

 

Conversion Ratio Conversion ratio =

Income adjustments due to dilutive financial instruments Newly issuable shares due to dilutive financial instruments

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The dilutive effect of financial instruments (for example, options warrants, and convertible bonds) on EPS is calculated starting with the instrument with the lowest conversion rate (i.e. most dilutive), and working up to the instrument with the highest conversion rate (i.e. least dilutive).

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Step 1: calculate the effect of options and warrants on EPS 

Treasury Method: Q: Option exercise price < Market price No  Yes

Options have dilutive effect them in diluted EPS:

 include

1. Assume all options are exercised

 

add new shares. 2. Assume proceeds (# shares x exercise price) are used to repurchase previously issued common shares   subtract these shares.

Options do not have dilutive effect  not included in diluted EPS.

 

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Example: Now assume that Solomon Corporation issued Example: Now options to buy 20,000 shares of common stock at $100 per share. The market price is $114. What is the diluted EPS?  

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Option exercise price 100$ < Market price 114$  114$   Upon full exercise of option  additional 20,000 shares The proceeds 20,000 X $100 = $2,000,000 are assumed to be used to repurchase previously issued common shares at the $114 market price. $2,000,000 $114 per share





17,544 shares

The dilution effect: 20,000 – 17,544 = 2,456 shares - 70,000  $6.75 per share Diluted EPS   $1,257,331   173,334  2,456

 

Step 2: calculate effect of convertible securities on EPS  ‘if-converted method’ ((one one convertible security) security) 

Increase in EPS denominator: denominator: calculate additional shares under full conversion.

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Increasehad in EPS numerator Calculate increasebonds/preferred in net income if interest not numerator: been paid :on the convertible shares. increase in (after tax) net income  Diluted EPS After step 1 Conversion ratio= ratio= # shares converted  Yes

No

Dilutive effect effect::  Add increase

No dilutive effect effect:: leave

in numerator and Denominator to Dilutive EPS. EPS.

Dilutive EPS after step 1 as-is.

 

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 Solomon Corporation also has: Example cont’: cont’: Solomon 

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$1,000,000 of 5% convertible bonds, with par (face) value of $1,000 per bond Each $1,000 bond pays interest of $50 per year and is convertible into 10 shares of common stock. 35% tax rate

What is the dilutive EPS now?

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Increase in denominator: 1,000 x 10 = 10,000 shares

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Increase in numerator: 1000 x $50 x (1-0.35)=$32,500 

32,500 10,000

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3.25  6.75

$1,257,331- 70,000  32,500 Diluted EPS   173,334   2,456  10,000



$6.57 per share

 

Summary of example Basic EPS = $6.85 (slide #4)

1. After considering effect of options = options = $6.75 (slide #11)

2. After considering effect of convertible bonds = bonds = $6.57 (slide #13) Q: Why does dilution effect of options always come before convertibles? Q: Why

 

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 method If converted  method

with multiple 

convertible securities Rank all convertible securities by conversion ratio; take convertible with lowest conversion ratio * For the chosen convertible security check: increase in (after tax) net income  Diluted EPS After step 1 # shares converted No: Anti-dilutive No: Anti-dilutive

 Yes: Dilutive  Yes: Dilutive

Calculate New EPS

Stop

Take the convertible with the next lowest conversion ratio * Options have lower conversion ratio, therefore come before convertibles.

 

 

Exercises 

E15-14



P15-4

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P15-12

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