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Unformatted text preview: ACG 3141: Chapter 19
Share Based Compensation and Earnings per Share
Part 2 (Class 25) Diluted Earnings Per Share 1 Topics
Finish Basic Earnings Per Share Go over Class 24 Homework Diluted Earnings Per Share Describe how options, rights, and warrants are incorporated in the calculation of EPS (Treasury Stock Method). Describe how convertible securities are incorporated in the calculation of EPS (If Converted Method). Explain the way contingently issuable shares are incorporated in the calculation of EPS. Earnings Per Share Disclosures
2 Intrinsic Value
Intrinsic value is the benefit the holder of an option Intrinsic would realize by exercising the option rather than buying the underlying stock directly. An option that permits an employee to buy $25 stock for $10, has an intrinsic value of $15. an
Options have a time Options value because the holder of an option does not have to pay the exercise price until the option is exercised. option
3 Dilutive Securities All of what we are going over next has the potential to increase the denominator of the EPS calculation (and, hence, decrease, or dilute, EPS). These securities are known as “potentially dilutive” because they represent potential common shares. Options and Warrants Convertible Securities (Debt and Preferred Stock). Contingently Issuable Shares. If a security is ANTIDILUTIVE (i.e., will not decrease EPS), we do not include it in the diluted EPS calculation. Worst case scenario: If some securities are dilutive and some antidilutive, only the dilutive securities are included (they are not netted). 4 Diluted Earnings Per share
Complex Capital Structure
(dual EPS) Potential Common Shares: •Stock options, rights, and warrants •Convertible bonds and stock •Contingent common stock issues
Contingently Contingently issuable shares shares Stock Options Treasury Treasury stock method stock Convertible Convertible securities securities Ifconverted Ifconverted method method Dilution/Antidilution Test 5 Complex Capital Structure
Dual presentation of Earnings Per Share:
Basic Basic EPS Diluted EPS Diluted 6 Diluted EPS includes the effect of all potential dilutive common shares that were outstanding during the period. Companies will not report diluted EPS if the securities in their capital structure are antidilutive. That is, taking them into account would INCREASE Basic EPS
7 Learning Objectives
Describe how options, rights, and warrants are incorporated in the calculation of EPS. 8 Options, Rights, and Warrants
Stock Options, Stock Rights and Stock warrants each give their holders the right to acquire common stock, usually at a specified exercise price. Thus, they are potential common stock that could dilute EPS. To determine the potential dilution (if any), we use the “Treasury Stock” method. The treasury stock method The treasury assumes that proceeds from the exercise of options are used to purchase treasury shares. This method usually results in a net increase in shares included in the denominator of the calculation of diluted earnings per share. of Exercise Exercise Price At Price At Used to average market price price Purchase Purchase treasury shares shares
9 Options, Rights, and Warrants
Diluted EPS – Options and Warrants
Measure the dilutive effects of potential conversion using the treasurystock method.
This method assumes:
(1) company exercises the options or warrants at the beginning of the year (or date of issue if later) at the average market price, and note that this deemed exercise will increase the # shares outstanding (2) that it uses those proceeds to purchase common stock for the treasury. note that this deemed purchase will decrease the # shares outstanding.
10 Options, Rights, and Warrants
1) Determine # Shares deemed issued from 1) exercise exercise
1a) Determine deemed cash proceeds from 1a) exercise. exercise. 1b) Determine new shares from assumed exercise 1b) of stock options. of 11 Options, Rights, and Warrants
2) Determine # Shares deemed repurchased: 2) Compute shares purchased for the treasury. Compute
Deemed Proceeds from Exercise (1a) ÷ Deemed Average market price per share (given) = Shares deemed repurchased 12 Options, Rights, and Warrants
3) Subtract 2 from 1b to get the # of shares by 3) which to increase the EPS denominator. This net amount is known as the “incremental increase”. “incremental
New shares from assumed exercise (1b) Less: Treasury shares assumed purchased (2) Incremental Increase (3) 13 Treasury Stock Method
Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is denominator a. 25,000 shares a. b. 5,000 shares b. c. 3,125 shares d. 1,875 shares 14 Treasury Stock Method
Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is denominator a. 25,000 shares a. b. 5,000 shares b. New shares = 5,000 c. 3,125 shares Treasury shares = 3,125 d. 1,875 shares (5,000 × $50) ÷ $80 Incremental shares = 1,875 (5,000  3,125) (5,000
15 Options Example
(EPS with Options) Venzuela Company’s net income for 2007 is $50,000. The only potentially dilutive securities outstanding were 1,000 options issued during 2006, each exercisable for one share at $6. None has been exercised, and 10,000 shares of common were outstanding during 2007. The average market price of the stock during 2007 was $20. Instructions (a) Compute diluted earnings per share. (b) Assume the 1,000 options were issued on October 1, 2007 (rather than in 2006). The average market price during the last 3 months of 2007 was $20.
16 Options, Rights, and Warrants
a) Compute diluted earnings per share for 2007.
TreasuryStock Method TreasuryStock Pr oceeds if shar es issued (1,000 x $ 6) Pur chase pr ice f or t r easur y shar es S har es assumed pur chased S har es assumed issued I ncr ement al shar e incr ease $ 6,000 20 300 1,000 700 ÷ $ 17 Options Example, cont’d
(a) Compute diluted earnings per share for 2007. When calculating Diluted EPS, begin with Basis EPS. Diluted EPS
$50,000 10,000 + = +
700 $50,000 = $4.67
10,700 Basic EPS = 5.00 Options
18 Options Example, cont’d
(b) Compute diluted earnings per share assuming the 1,000 options were issued on October 1, 2007.
TreasuryStock Method TreasuryStock Pr oceeds if shar es issued (1,000 x $ 6)
Pur chase pr ice f or t r easur y shar es S har es assumed pur chased S har es assumed issued I ncr ement al shar e incr ease W eight f or 3 mont hs assumed out st anding Weight ed incr ement al shar e incr ease
x $ 6,000 20 300 1,000 700 3/ 12 175 ÷ $ 19 Options Example, cont’d
(b) Compute diluted earnings per share assuming the 1,000 options were issued on October 1, 2007. Diluted EPS
$50,000 $50,000 =
10,000 = $4.91
10,175 + 175 Basic EPS = 5.00 Options 20 Options, Rights, and Warrants When the exercise price When exceeds the market price, the securities are antidilutive. antidilutive
Why? Because the employees would purchase less stock than the company would repurchase. If securities are antidilutive, they are EXCLUDED from the diluted EPS calculation Make sure to separately calculate the effect of each option and warrant (if terms are different).
21 Learning Objectives
Describe how convertible securities are incorporated in the calculation of EPS. 22 Convertible Securities
Convertible securities (debt or preferred stock) give their holders the right to acquire common stock through conversion. Thus, they are potential common stock that could dilute EPS. To determine the potential dilution (if any), we use the “If Converted” method. Convertible debt and equity securities securities
The method assumes conversion occurs as of the The beginning of the period or date of beginning issuance, if later. issuance
23 The ifconverted method is used for ifconverted Convertible Securities
The assumed conversion of convertible bonds or preferred stock has two effects on dilutive earnings per share: earnings
Increases the denominator by the number of common Increases shares issuable upon conversion. shares Increases the numerator by decreasing a) aftertax Increases interest expense on convertible bonds, or b) dividends interest on convertible preferred stock. on Note: Apply the ifconverted test on a securitybysecurity basis
24 Convertible Bonds Example
In 2006 Chirac Enterprises issued, at par, 60, $1,000, 8% bonds, each convertible into 100 shares of common stock. Chirac’s net income for the year was $2,580 including $4,800 interest expense on the bonds (60 x $1,000 x 8%). Assume that Chirac’s tax rate is 40%. Throughout 2007, 2,000 shares of common stock were outstanding; none of the bonds was converted or redeemed. Instructions (a) Compute diluted earnings per share for 2007
25 Convertible Bonds Example, cont’d
(a) Compute diluted earnings per share for 2007. When calculating Diluted EPS, begin with Basic EPS. Basic EPS
Net income = $2,580 = $1.29
Weighted average shares = 2,000 26 Convertible Bonds Example, cont’d
(a) Compute diluted earnings per share for 2007.
Add back bond interest expense, net of tax Diluted EPS
$2,580 + $4,800 (1  .40) $5,460 =
2,000
Basic EPS = 1.29 =
8,000 $.68 + 6,000 60 bonds convertible into 100 shares of stock 60 x 100 = 6,000
27 Convertible Pref. Stock Example
(Convertible Preferred Stock) Prior to 2007, Prancer Company issued 30,000 shares of 6% convertible, cumulative preferred stock, $100 par value. Each share is convertible into 5 shares of common stock. Net income for 2007 was $1,200,000. There were 600,000 common shares outstanding during 2007. There were no changes during 2007 in the number of common or preferred shares outstanding. Instructions
(a) Compute diluted earnings per share for 2007.
28 Convertible Pref. Stock Example, con’td
(a) Compute diluted earnings per share for 2007. When calculating Diluted EPS, begin with Basic EPS. Basic EPS
Net income $1,200,000 – Pfd. Div. $180,000* = $1.70
Weighted average shares = 600,000 * 30,000 shares x $100 par x 6% = $180,000 dividend 29 Convertible Pref. Stock Example, cont’d
(a) Compute diluted earnings per share for 2007. Diluted EPS
$1,200,000 – $180,000 600,000 + $180,000 + 150,000* $1,200,000 = 750,000 = $1.60
Basic EPS = 1.70
*(30,000 x 5)
30 Convertible Pref. Stock Example, cont’d
What would happen if, in this example, each share of preferred is convertible into 3 shares of common stock. Diluted EPS
$1,200,000 – $180,000 600,000 + $180,000 + 90,000* $1,200,000 = 750,000 = $1.74
Basic EPS = 1.70 Effect on EPS = 2.00
*(30,000 x 3)
31 Convertible Pref. Stock Example, cont’d
Because Diluted EPS is greater than Basic EPS, the security is ANTIDILUTIVE and will not be included in the Diluted EPS computation. Diluted EPS
$1,200,000 – $180,000 600,000 Basic = Diluted EPS + $180,000 + 90,000*
Antidilutive $1,200,000 = 750,000 = $1.70
Basic EPS = 1.70 Effect on EPS = 2.00
*(30,000 x 3)
32 Convertible Securities
Dilutive earnings per share may decrease or Dilutive increase after the assumed conversion. increase If dilutive earnings per share If decreases, the securities are dilutive decreases the dilutive and are assumed converted. converted If dilutive earnings per share increases, the securities are antidilutive and are antidilutive not considered converted. not
33 IfConverted Method
Assume net income (after tax) of $500,000, Assume cumulative convertible preferred stock dividends of $25,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The convertible preferred stock is convertible into 5,000 shares of common stock. Is the convertible preferred stock dilutive? Is 34 IfConverted Method
EPS without conversion: $500,000 – $25,000 = $9.50 EPS 50,000 shares 50,000
If the preferred stock is converted, we would not have If dividends and the number of shares of common stock would increase by 5,000 shares. There is not a tax effect. increase EPS after assumed conversion: $500,000 – $0 = $9.09 EPS 55,000 shares Dilutive
35 IfConverted Method
Assume net income (after tax) of $500,000, convertible bonds with interest expense of $50,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The bonds are convertible into 2,000 shares of common stock. Are the convertible bonds dilutive? Are 36 IfConverted Method
EPS without conversion: $500,000 $500,000 = $10.00 EPS 50,000 shares 50,000
If the bonds are converted, net income would increase by If $35,000 (after taxes) and the number of shares of common stock would increase by 2,000 shares. EPS after assumed conversion:
$535,000 = $10.29 EPS $10.29 52,000 52,000 shares shares Antidilutive
37 Order of Entry for Multiple Convertible Securities When a company has more than one When potentially dilutive security, they are considered for inclusion in dilutive EPS in sequence from the most dilutive to the least dilutive. dilutive 38 Convertible Securities: Testing for Dilution Test for dilution by looking at the incremental effect of each security. Incremental Effect: Create a fraction in which the numerator and denominator are the changes caused by the convertible security. If the result is greater than Basic EPS, the security is ANTIDILUTIVE. If the result is less than Basic EPS, the security is DILUTIVE. If the security is dilutive, add to the diluted EPS equation from the most dilutive (i.e., the smallest result) to the least dilutive. Note on Options and Warrants: Don’t include options and warrants in this test / ranking system. Options and warrants are antidilutive (and not included at all) only if the exercise price is higher than the market price (see Slide 21). If the exercise price is lower than the market price, these securities will always be dilutive. The incremental test and ranking applies only to convertible securities.
39 Dilution Example Basic EPS is $1.89 Convertible Debt: 10%, $300 million face amount issued in 2005, convertible into 12 million common shares. The tax rate is 40%. Noncumulative Convertible Preferred Stock: 10 million, 8%, cumulative, $10 par, shares issued in 2002, convertible into 5 million shares The securities were issued in a prior period Required: Test each security for dilution. If dilutive, in what order do the securities enter the Diluted EPS calculation?
40 Dilution Example, cont’d Convertible Debt: In the numerator, saved interest (net of tax is added back). In the denominator the amount of shares if converted is added. Interest saved (NOT): 10% x 300 x (1.4) = $18 Converted shares: 12 (given) $18 ÷ 12 = $1.50 Because the result ($1.50) is less than basic EPS ($1.89), this security is dilutive and must be included in the diluted EPS calculation. Convertible Preferred: In the numerator, preferred stock dividends declared are added back (these were subtracted from EPS in the Basic EPS equation). In the denominator, the amount of shares converted is added. Dividends saved: $10 x 8% x 10 = $8 Converted shares: 5 (given) $8 ÷ 5 = $1.60 Because the result ($1.60) is less than basic EPS ($1.89), this security is dilutive and must be included in the diluted EPS calculation. The convertible debt has the smallest result, indicating that it is more dilutive than the convertible stock. Thus, the convertible debt is added first to basic EPS in calculating Diluted EPS.
41 Comprehensive Example
Illustration 911 Sovran reported net income of $154 million in 2006 (tax rate 40%). The average market price of the common shares was $25 per share. Its capital structure included: Common Stock: Jan 1 60 million common shares outstanding Mar. 1 12 million new shares were sold June 17 A 10% stock dividend was distributed Oct. 1 8 million shares were reacquired as treasury stock Nonconvertible preferred issued in 2005. 5 million, 8% 10 par Executive Stock Options: Granted in 2004, exercisable for 15 million shares at an exercise price of $20 per share. Convertible Bonds: 10%, $300 million face issued in 2005, convertible into 12 million common shares. Cumulative Convertible Preferred Stock: Issued in 2002. 10 million, 8%, $10 par convertible into 5 million shares. Cumulative. Required: Calculate Basic and Diluted Earnings per Share
42 Comprehensive Example, cont’d
Basic EPS: Numerator: Net Income – Preferred Stock Dividends $154  4– 8 = $142 nonconvertible preferred: 5 x 8% x $10 = 4 convertible preferred: 10 x 8% x $10 = 8 Denominator: Weighted Average of Common Shares 60 10 7 (2) 75 Stock Dividends: Treated as being Stock made on the weighted shares outstanding at the time of dividend (or stock split). However, do not adjust for time of the dividend. adjust At 6/17, there were 70 weighted At shares outstanding. 10% of 70 shares = 7. No adjustment is made reflecting that the dividend itself occurred midyear. itself Jan 1 60 x 12/12 = Mar 1 12 x 10/12 = Jun 17 70 x .10 x 12/12 = Oct 1 8 x 3/12= Weighted Average Basic EPS = $142 ÷ 75 = $1.89 43 Comprehensive Example, cont’d
Diluted EPS: There are 3 potential common stock securities to consider. First, test for dilution. If dilutive, adjust the EPS numerator and denominator accordingly. If antidilutive, leave out of calculation. Executive Stock Options: Because the exercise price ($20) is less than the market price ($25), these are dilutive and must be included. With stock options, there is no adjustment to the numerator of the calculation, there is only an adjustment to the denominator. First, we add the # of shares deemed sold under the exercise, then subtract the # of shares deemed purchased for treasury stock: 15 million shares deemed purchased 12 shares deemed purchased 3 share added to denominator (15 x $20) ÷ $25 = 12 shares deemed purchased with the proceeds of the sale 44 Comprehensive Example, cont’d
Convertible Debt: In the numerator, saved interest (net of tax is added back). In the denominator the amount of shares if converted is added. Interest saved (NOT): 10% x 300 x (1.4) = $18 Converted shares: 12 (given) $18 ÷ 12 = $1.50 Because the result ($1.50) is less than basic EPS ($1.89), this security is dilutive and must be included in the diluted EPS calculation. Convertible Preferred: In the numerator, preferred stock dividends declared are added back (these were subtracted from EPS in the Basic EPS equation). In the denominator, the amount of shares converted is added. Dividends saved: $10 x 8% x 10 = $8 Converted shares: 5 (given) $8 ÷ 5 = $1.60 Because the result ($1.60) is less than basic EPS ($1.89), this security is dilutive and must be included in the diluted EPS calculation. The convertible debt has the smallest result, indicating that it is more dilutive than the convertible stock. Thus, the convertible debt is added first to basic EPS in calculating Diluted EPS.
45 Comprehensive Example, cont’d
Numerator: Denominator: 154 – 4 – 8 + 18 + 8 75 +3 + 12 + 5 = = $168 95 Diluted EPS = $165 ÷ 95 = $1.77 46 Learning Objectives
Explain the way contingently issuable shares are incorporated in the calculation of EPS. 47 Contingently Issuable Shares Contingent shares are issuable in the Contingent future for little or no cash consideration upon the satisfaction of certain conditions. conditions. Future
48 Contingently Issuable Shares
Contingent shares are included in Contingent dilutive EPS if: dilutive
Shares are issued Shares merely due to passage of time. of Some target performance Some level has already been met and is expected to continue to the end of the contingency period. contingency Example: Additional shares may be Example: issued based on future earnings.
49 Contingently Issuable Shares
Contingent shares are considered Contingent outstanding common shares and are included in basic EPS as of the date that all necessary conditions have been satisfied. necessary 50 Summary
Dilutive Effect Shown? Basic EPS Diluted EPS no yes no no yes yes Potential Common Shares Stock options (or warrants, rights) Convertible securities (bonds, notes, preferred stock) Contingently issuable shares 51 Summary
I mpact Potential Common Shares Stock options (or warrants, rights) Convertible bonds or notes Numerator None Add after tax i nterest Add back dividends declared Denominator Add incremental shares Add shares i ssuable upon conversion Add shares i ssuable upon conversion Add shares i ssuable None Convertible preferred Contingently issuable shares Conditions being currently met Conditions not being met None None 52 Learning Objectives
Review Financial Statement Disclosures related to Earnings per Share 53 Earnings Per Share Disclosure
Report EPS data separately for: 1. Income from Continuing Operations 2. Separately Reported Items a) Discontinued Operations b) Extraordinary Items 3. Net Income 54 EPS Disclosures Basic and Diluted EPS should be reported on the face of the income statement. If no potentially dilutive securities, Basic EPS only Reconciliation of Basic EPS numerator and denominator to Diluted EPS numerator and denominator Any adjustment to Basic numerator for preferred dividends Any potential common shares not included because antidilutive Additional disclosures 55 FedEx Income Statement
Detail 2004 2003 2002 56 FedEx 2004 EPS Footnote 57 ...
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 Financial Accounting, Earnings Per Share

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