In-class Exercise (Diluted EPS) Solution
Part 1: Diluted EPS, if-converted method
Thompson Corporation has net income of $210,000 for the year and a weighted-average
number of common shares outstanding during the period of 100,000 shares. The basic earnings
per share is thus $2.10 ($210,000/100,000). The company has two convertible debenture bond
issues outstanding. One is a 6 percent issue sold at 100 (total $1,000,000) in a prior year and
convertible into 20,000 common shares. The other is a 10 percent issue sold at 100 (total
$1,000,000) on April 1 of the current year and convertible into 32,000 shares. The tax rate is
40%.
Required:
Calculate the Diluted Earnings Per Share using the if-converted method.
Step 1 (description)
To determine the numerator for diluted EPS, fist add back the interest on the if-converted
securities, less the related tax effect.1 Because the if-converted method assumes conversion as of
the beginning of the year, the firm assumes that it pays on interest on the convertibles during the
year. The interest on the 6% convertibles is thus $60,000 ($1,000,000 * 6%). The increased tax
expense is $24,000 ($60,000 * 40%). The interest added back, net of taxes, is therefore $36,000
($60,000 - $24,000, or simply $60,000 * [1 – 0.40]).
Because the firm issued the 10% convertibles after the beginning of the year, it needs to weight
the shares. In other words, it considers these shares to have been outstanding from April 1 to the
end of the year. As a result, the interest adjustment to the numerator for these bonds reflects the
interest for only nine months. Thus the interest added back on the 10% convertible is $45,000
($1,000,000 * 10% * (9/12) * [1 – 0.40]).
Step 1 (computations)
Net income for the year 210,000
Add: adjustment for interest (net of tax)
6% debentures ($60,000 * [1 - .40]) 36,000
10% debentures ($100,000 * (9/12) * [1 - .40]) 45,000
Adjusted net income 291,000
1
We add back the interest, because if we convert the debt to equity we don’t need to pay interest anymore.
Step 2 (description)
We now calculate the weighted-average number of shares outstanding.
Step 2 (computations)
Weighted-average number of shares outstanding 100,000
Add: shares assumed to be issued:
6% debentures (as of beginning of the year) 20,000
10% debentures (as of date of issue, April 1; 9/12 *
32,000) 24,000
144,000
Step 3: Computation of Diluted EPS
291,000
= $2.02
144,000
Part 2: Diluted EPS, Treasury Stock Method
Use the information below to calculate diluted EPS using the treasury stock method:
Net income: $220,000
Weighted-average shares outstanding: 100,000
Basic EPS: $2.20
The average number of stock options outstanding throughout the year was 5,000.
The stock options give holders the right to purchase shares of stock at a price of $20 per share.
The average stock price of the firm during the year was $28 per share.
Average number of shares related to options outstanding 5,000
Option price per share 20
Proceeds upon exercise of options (5,000 * $20) 100,000
Average market price of common stock 28
Treasury shares that could be repurchased with the proceeds ($100,000 / $28) 3,571
Excess of shares under option over the treasury shares that could be repurchased (5,000 - 3,571) 1,429
(potential common incremental shares)
Net Income 220,000
Weighted-average of common shares outstanding 100,000
Diluted EPS (220,000 / [100,000 + 1,429]) 2.17
