Earnings Per Share (EPS)

RCJ Chapter 15 (836-842)

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Key Issues1. Basic EPS 2. Weighted average common shares3. Pecking order4. Treasury stock transactions5. Dilution6. Diluted EPS7. options and warrants: treasury stock method8. Convertible bonds and preferred stock: if

converted method9. Determining dilution vs anti-dilution

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Basic EPS

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

exercises, etc.. 

goutstandinstock common ofnumber average Weighteddividends Preferred - incomeNet EPS Basic

4

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

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?

Time span(a) Shares outstanding

(b) Portion of year

Weighted shares (col. a x col. b)

Jan 1 - Aug 31 160,000 2/3 106,667 Sep1 - Dec 31 200,000 1/3 66,667

173,333

shareper 85.6$shares 334,173$70,000-$1,257,331EPS Basic

Preferred dividends = 10,000 x 100 x0.07 = $70,000

Basic EPS - Example

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Basic EPS (cont’d)EPS is from common shareholders’ viewpoint

Pecking order of suppliers of capital:1. Debt holders2. Preferred stock holders3. Common stock holders 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:

DR Treasury stock (contra O/E A/C) CR Cash

2. resale of treasury shares: DR CashDR APC

CR Treasury stock (at cost, from 1.)CR APC

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

or

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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: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.

(1) Options; and (2) Convertible securities can: Decrease EPS dilutive Increase EPS anti-dilutive

Net income- Preferred dividends +

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

Weighted average number of common shares outstanding

+Diluted EPS =

Only dilutive securities are included in the diluted EPS calculation

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Conversion Ratio

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).

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

Conversion ratio =

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

Q: Option exercise price < Market price

Options have dilutive effect include them in diluted EPS: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.

Yes No

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

shares 544,17shareper 114$000,000,2$

shareper 75.6$2,456173,33470,000-$1,257,331 EPS Diluted

Option exercise price 100$ < Market price 114$

Upon full exercise of option additional 20,000 shares

The proceeds 20,000 X $100 = $2,000,000are assumed to be used to repurchase previously issued common shares at the $114 market price.

The dilution effect: 20,000 – 17,544 = 2,456 shares

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

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

Increase in EPS numerator: Calculate increase in net income if interest had not been paid on the convertible bonds/preferred shares.

1 stepAfter EPS Dilutedconverted shares #

incomenet )(after taxin increase

Yes No

Dilutive effect: Add increase in numerator and Denominator to Dilutive EPS.

No dilutive effect: leave Dilutive EPS after step 1 as-is.

Conversion ratio=

Example cont’: Solomon Corporation also has: $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? Increase in denominator: 1,000 x 10 = 10,000 shares Increase in numerator: 1000 x $50 x (1-0.35)=$32,500

75.625.3000,10500,32

shareper 57.6$10,0002,456173,334

32,50070,000-$1,257,331 EPS Diluted

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Summary of exampleBasic EPS = $6.85 (slide #4)

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

2. After considering effect of convertible bonds = $6.57 (slide #13)

Q: Why does dilution effect of options always come before convertibles?

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If converted method with multiple convertible securities

Rank all convertible securities by conversion ratio; take convertible with lowest conversion ratio*

1 stepAfter EPS Dilutedconverted shares #

incomenet )(after taxin increase

Yes: Dilutive Calculate New EPS

Take the convertible with the next lowest conversion ratio

No: Anti-dilutive

Stop

For the chosen convertible security check:

* Options have lower conversion ratio, therefore come before convertibles.

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Exercises E15-14 P15-4 P15-12