Ch 20

Basic EPS equation:

(Net Income - Preferred Dividends) / Weighted Average Number of Common Shares Outstanding

How does conversion of preferred stock affect the calculation for diluted EPS?

*Denominator:* The if-converted assumption puts the conversion of convertible preferred stock into common stock at the earliest possible point during the year—increase the denominator by # of shares assumed to be issued at conversion. *Numerator:* The firm can ignore preferred dividends in the numerator; no tax impact because preferred dividends are not tax-deductible.

Which versions of EPS are firms required to put on their income statements?

- Basic EPS - Diluted EPS

Diluted EPS

- Captures the reduction in basic EPS that would occur if securities (e.g., stock options, convertible debt) that are convertible into shares of common stock are assumed to have been converted. - Only securities that decrease EPS (i.e., dilutive) are considered. Securities that increase EPS (i.e., antidilutive) are ignored. - Diluted EPS presents a "worst case scenario."

Basic EPS

- Indicates the amount of Net Income (after dividends owed to preferred stockholders) for each share of common stock outstanding. - Basic EPS only considers the average number of common shares that were actually outstanding during the fiscal year.

How do options and warrants impact diluted EPS?

- The treasury stock method assumes that firms use the proceeds from the hypothetical exercise of in-the-money (not out-of-the-money) options or warrants to purchase treasury stock at the average market price of the common stock for the period. - Subtracting the treasury shares assumed to be repurchased from the total number of shares issued on the assumed exercise determines the incremental shares remaining in the market. - The incremental shares are added to the denominator of diluted EPS.

How do firms adjust for antidilutive securities?

- When considering the effects of options and warrants on diluted EPS, the security must be in-the-money—that is, the exercise price must be less than the market price—to assume exercise. - An investor would not exercise out-of-the-money securities if it were less expensive to purchase securities in the market. - In-the-money securities result in incremental shares; out-of-the-money securities result in negative incremental shares and are antidilutive. - With out-of-the-money securities, the issuing company has more funds received than it needs to buy back the issued shares, and it will be able to acquire more shares than it issued. - The number of outstanding shares will decrease, and EPS will increase.

Under the if-converted assumption, a company assumes that both hypothetical and actual conversions of potentially dilutive securities occur:

1. At the beginning of the year, if the potentially dilutive security is outstanding as of the beginning of the year. 2. At the issue date of the dilutive security, if the potentially dilutive security is issued during the year.

When do convertible preferred shares convert?

1. If convertible preferred shares were outstanding as of the beginning of the year, assume conversion occurs at the beginning of the year. 2. If preferred stock issued during the year, assume conversion at issue date.

Equation for incremental income per share effect

Amount added back to preferred dividends/ number of common shares

When does an antidilutive effect occur?

An antidilutive effect occurs if EPS increases or loss per share decreases when assuming the conversion of securities or exercise of options and warrants.

What is EPS?

EPS is as an overall measure of firm performance, expressed in terms of each share of common stock outstanding for a particular reporting period.

What are options/warrants?

Options and warrants give the holder the right (but not obligation) to acquire common stock from the issuer over a fixed time period, at a specified price.

Summary of Diluted EPS calculations?

See slide 29

What else impacts the weighted average number of common shares outstanding?

Stock splits and stock dividends also impact the computation of weighted-average common shares outstanding. The accounting assumes that a stock split or stock dividend occurs at the beginning of the year *for shares that were outstanding as of the beginning of the year.*

Diluted EPS numerator

The if-converted assumption affects the treatment of interest expense for convertible debt in two ways: 1. The firm avoids the interest expense on convertible debt for the period of the year the debt was assumed to be converted into common stock. For debt issued at a discount or premium, the firm uses the effective interest rate to compute interest expense. 2. Interest on debt is generally tax-deductible. Therefore, the firm adjusts the net income in the numerator of the diluted EPS for the reduced interest expense, net of tax.

Diluted EPS denominator

The if-converted assumption puts the conversion of convertible debt into common stock at the earliest possible point during the year—increase the denominator by # of shares assumed to be issued at conversion.

true or false: For share issuances that occur before the split or dividend (but after the beginning of the year), the retroactive assumption assumes that the split or dividend occurred at the time of the issuance.

true