Earnings Per Share (EPS)

1. Earnings Per Share (EPS) RCJ Chapter 15 (836-842)

2. Key Issues • Basic EPS • Weighted average common shares • Pecking order • Treasury stock transactions • Dilution • Diluted EPS • options and warrants: treasury stock method • Convertible bonds and preferred stock: if converted method • Determining dilution vs anti-dilution Paul Zarowin

3. Basic EPS • weight shares outstanding by fraction of year; • changes due to share repos, issuances, option exercises, etc..  Paul Zarowin

4. Basic EPS - Example • On January 1, 2001 Solomon Corporation had: • 160,000 common shares outstanding. • 10,000 preferred shares, $100 par value, 7% • On September 1, 2001 the company issued 40,000 additional common shares. • The net income for 2001: $1,257,331 • What is the basic EPS? Preferred dividends = 10,000 x 100 x0.07 = $70,000

5. Basic EPS (cont’d) EPS is from common shareholders’ viewpoint Pecking order of suppliers of capital: • Debt holders • Preferred stock holders • Common stock holders • Why are preferred dividends subtracted, but not bond interest? Ex. E15-14; P15-4 Paul Zarowin

6. Effect of Treasury Stock Transactions 1. Purchase of treasury shares: DR Treasury stock (contra O/E A/C) CR Cash 2. resale of treasury shares: DR Cash DR APC CR Treasury stock (at cost, from 1.) CR APC DR (or CR) to APC is economic loss (or gain) that is not recognized in accounting or Paul Zarowin

7. Effect of Treasury Stock Transactions (cont’d) Key point: Transactions in own common stock don’t affect NI (proprietary viewpoint), only affect number of shares outstanding; so firms can manipulate EPS Q:How does transaction timing during the year affect EPS?  Ex. E15-16; P15-8 Paul Zarowin

8. Diluted EPS • SFAS No. 128 requires companies with complex capital structures to compute another measure called diluted earnings per share. • (1) Options; and (2) Convertible securities can: • Decrease EPS  dilutive • Increase EPS  anti-dilutive Income adjustments due to dilutive financial instruments Net income - Preferred dividends + Diluted EPS = Newly issuable shares due to dilutive financial instruments Weighted average number of common shares outstanding + Only dilutive securities are included in the diluted EPS calculation Paul Zarowin

9. Conversion Ratio Income adjustments due to dilutive financial instruments • The dilutive effect of financial instruments (for example, options warrants, and convertible bonds) on EPS is calculated starting with the instrument with the lowest conversion rate (i.e. most dilutive), and working up to the instrument with the highest conversion rate (i.e. least dilutive). Conversion ratio = Newly issuable shares due to dilutive financial instruments Paul Zarowin

10. Step 1: calculate the effect of options and warrants on EPS • Treasury Method: Q: Option exercise price < Market price No Yes Options have dilutive effect  include them in diluted EPS: 1. Assume all options are exercised  add new shares. 2. Assume proceeds (# shares x exercise price) are used to repurchase previously issued common shares  subtract these shares. Options do not have dilutive effect  not included in diluted EPS. Paul Zarowin

11. Example: Now assume that Solomon Corporation issued options to buy 20,000 shares of common stock at $100 per share. The market price is $114. What is the diluted EPS? • Option exercise price 100$ < Market price 114$ • Upon full exercise of option  additional 20,000 shares • The proceeds 20,000 X $100 = $2,000,000 are assumed to be used to repurchase previously issued common shares at the $114 market price. • The dilution effect: 20,000 – 17,544 = 2,456 shares

12. Step 2: calculate effect of convertible securities on EPS ‘if-converted method’ (one convertible security) • Increase in EPS denominator: calculate additional shares under full conversion. • Increase in EPS numerator: Calculate increase in net income if interest had not been paid on the convertible bonds/preferred shares. Conversion ratio= Yes No Dilutive effect: Add increase in numerator and Denominator to Dilutive EPS. No dilutive effect: leave Dilutive EPS after step 1 as-is. Paul Zarowin

13. Example cont’: Solomon Corporation also has: • $1,000,000 of 5% convertible bonds, with par (face) value of $1,000 per bond • Each $1,000 bond pays interest of $50 per year and is convertible into 10 shares of common stock. • 35% tax rate • What is the dilutive EPS now? • Increase in denominator: 1,000 x 10 = 10,000 shares • Increase in numerator: 1000 x $50 x (1-0.35)=$32,500

14. Summary of example Basic EPS = $6.85 (slide #4) 1. After considering effect of options = $6.75 (slide #11) 2. After considering effect of convertible bonds = $6.57 (slide #13) Q: Why does dilution effect of options always come before convertibles? Paul Zarowin

15. If converted method with multiple convertible securities Rank all convertible securities by conversion ratio; take convertible with lowest conversion ratio* For the chosen convertible security check: Yes: Dilutive No: Anti-dilutive Calculate New EPS Stop Take the convertible with the next lowest conversion ratio * Options have lower conversion ratio, therefore come before convertibles. Paul Zarowin

16. Exercises • E15-14 • P15-4 • P15-12 Paul Zarowin