Earnings Per Share (EPS)

RCJ Chapter 15 (836-842)

Key Issues
1. 2. 3. 4. 5. 6. 7. 8. Basic EPS Weighted average common shares Pecking order Treasury stock transactions Dilution Diluted EPS options and warrants: treasury stock method Convertible bonds and preferred stock: if converted method 9. Determining dilution vs anti-dilution

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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%

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 2/3 106,667 Sep1 - Dec 31 200,000 1/3 66,667 173,333

Basic EPS

$1,257,331 - $70,000 $6.85 per share 173 ,334 shares

Basic EPS (contd)

EPS is from common shareholders viewpoint Pecking order of suppliers of capital: 1. Debt holders 2. Preferred stock holders 3. 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 Cash DR APC CR CR

or

Treasury stock (at cost, from 1.) APC

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

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Effect of Treasury Stock Transactions (contd)

Key point: Transactions in own common stock dont 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.
Income adjustments due to Net income - Preferred dividends + dilutive financial instruments Weighted average number of common shares outstanding + Newly issuable shares due to dilutive financial instruments

Diluted EPS =

(1) Options; and (2) Convertible securities can: Only dilutive securities Decrease EPS dilutive are included in the diluted Increase EPS anti-dilutive EPS calculation
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Conversion Ratio
Conversion ratio = Income adjustments due to dilutive financial instruments Newly issuable shares due to dilutive financial instruments

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
Yes No

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

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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?

Option exercise price 100$ < Market price 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 17 ,544 shares $114 per share

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

Diluted EPS $1,257,331 - 70,000 $6.75 per share 173,334 2,456

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. increasein (after tax ) net income Diluted EPS After step1 Conversion ratio= # shares converted

Yes

No

Dilutive effect: Add increase

in numerator and Denominator to Dilutive EPS.

No dilutive effect: leave

Dilutive EPS after step 1 as-is.
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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

32 ,500 3.25 6.75 10 ,000

Diluted EPS

$1,257,331 - 70,000 32,500 $6.57 per share 173,334 2,456 10,000

Summary of example
Basic 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* For the chosen convertible security check:

increasein (after tax ) net income Diluted EPS After step1 # shares converted
Yes: Dilutive No: Anti-dilutive

Calculate New EPS Take the convertible with the next lowest conversion ratio

Stop

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

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Exercises

E15-14 P15-4 P15-12

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