Chapter 16: Convertible Securities, EPS

Question 1

—————–Background Information ———

Cauldron Company has net income for the year of $300,000 and a weighted-average number of common shares outstanding for the year of 125,000.

Therefore, basic EPS is $2.40 (300,000 / 125,000). In the previous year, Cauldron issued a $1,000,000 5%
convertible bond at par. The note is convertible into 28,000 common shares. The tax rate is 20%.

————- Question ——————-
Compute diluted EPS for Cauldron Company.

Answer 1

New numerator:
Net income 300,000
Add back after-tax interest 40,000 (= 50,000 * (1-.2))
Adjusted net income 340,000

New denominator:
Weighted average shares 125,000
Shares assumed to be issued 28,000
Adjusted shares 153,000

Diluted EPS: 340,000 / 153,000 = $2.22

This security is dilutive, so it would be included in the diluted EPS.

Question 2

—————–Background Information ———

Cauldron Company has net income for the year of $300,000 and a weighted-average number of common shares outstanding for the year of 125,000. In the previous year, Cauldron issued preferred stock paying a $50,000 annual dividend.

Therefore, basic EPS is $2.00 (250,000 / 125,000). The preferred stock is convertible into 20,000 common shares. The tax rate is 20%.

————- Question ——————-
Compute diluted EPS for Cauldron Company.

Answer 2

New numerator:
Net income 300,000
No subtraction of preferred dividends.

New denominator:
Weighted average shares 125,000
Shares assumed to be issued 20,000
Adjusted shares 145,000

Diluted EPS: 300,000 / 145,000 = $2.06 … not dilutive, so this is not included in diluted EPS.