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pheepa
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Posted: 26 Mar 2009 at 22:15 \| IP Logged

12/31/01 12/31/02

Outstanding shares of stock:
Common                                       110,000          ;     145,000
Convertible preferred               10,000                      0
8% convertible bonds           1,000,000    500,000

On May 1, 2002, the preferred shares were converted into 20,000 shares of common stock. The 8% bonds were convertible into 30,000 shares of common stock. On July 1st, $500,000 of the bonds were converted. Net Income was $850,000. Assume that the income tax rate was 30%. What is the basic earnings per share for 2002?

a. $6.80
b. 6.50
c. 6.54
d. 5.86

Can someone please help me with this question with an explanation. Thanks much.

Edited by pheepa on 26 Mar 2009 at 22:16

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divyagovil1
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Posted: 27 Mar 2009 at 00:47 \| IP Logged

Pheepa, Per my understanding :-

Basic EPS = Income available to common shareholders

Weighted average number of common shares outstanding

Per question, Income available to common shareholders = NI = $850,000

Calculation of Weighted average number of common shares outstanding:-

Date Transaction Change in shares Total shares

1/1 Shares o/s 110,000

5/1 Preferred shares

Converted 20,000 130,000

7/1 50% bonds

Converted 15,000 145,000

Now,

Total shares * Period outstanding = weighted average

110,000 4/12 (Jan-Apr) 36,667

130,000 2/12 (May-Jun) 21,667

145,000 6/12(July-Dec) 72,500

Weighted average shares outstanding 130,834

Thus, Basic EPS = 850,000/130,834

= $6.50

Hope it helps !

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jrupa
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Posted: 27 Mar 2009 at 02:08 \| IP Logged

but divya u have not give th effect of preffred divd and intrest on bond ... is that not needed?

neott
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Posted: 27 Mar 2009 at 02:38 \| IP Logged

Correct me if I'm wrong. I think this question has a bug because Basic EPS ignores the potential dilutive securities (in this case, convertible bonds) in calculation of Weighted Average of Common Shares Outstanding. I got this from Item III. Complex Capital Structure (Basic & Diluted EPS) on F7 , Becker.

Per my understanding, Basic EPS is used when an entity has a simple capital structure which has only common stock or nonconvertible preferred stock or nonconvertible bonds. The 15,000 common shares converted from bonds should not be included in weighted ave. commom shares outstanding. Instead, I would use the original 110K shares as the denominator.

Since this company has convertible bonds and preferred stocks, it should present both Basic EPS and Diluted EPS. The Basis EPS just ignores convertible securities while the Diluted EPS assumes all convertible securities were converted during the year.

The purpose of presenting both Basic and Diluted EPS is to test if those convertible securites would really dilute EPS, if yes, use Diluted, if no, use Basic. However, if we include that 15,000 shares converted shares in the the Basic EPS calculation, it will be diluted already and won't make a good comparison to the Diluted EPS.

Therefore I think the Basic EPS should be $850K/110K shares, or $7.72, which is not among the answers.

neott
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Posted: 27 Mar 2009 at 02:47 \| IP Logged

jrupa wrote:

but divya u have not give th effect of preffred divd and intrest on bond ... is that not needed?

Effect of Preferred Dividends:
1. the company has not declared dividends on pref. stock during the year
2. the question does not mention it's a cumulative pref. stock, so no dividend should be accumulated

Effect of Interest on Bonds:
This is added back to Net Income in calculating Diluted EPS while the question's asking for Basic EPS.

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