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Chapter 19 - Earnings per Share Learning Objectives. Know the difference between a simple and a complex capital structure, and understand how dilutive securities affect earnings per share computations.

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Chapter 19 - Earnings per ShareLearning Objectives

  • Know the difference between a simple and a complex capital structure, and understand how dilutive securities affect earnings per share computations.

  • Compute basic earnings per share, taking into account the sale and repurchase of stock during the period as well as the effects of stock splits and stock dividends.

  • Use the treasury stock method to compute diluted earnings per share when a firm has outstanding stock options, warrants, and rights.

    4. Use the if-converted method to compute diluted earnings per share when a company has convertible preferred stock or convertible bonds outstanding.


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Learning Objectives

  • Factor into the diluted earnings per share computations the effect of actual conversion of convertible securities or the exercise of options, warrants, or rights during the period, and understand the antidilutive effect of potential common shares when a firm reports a loss from continuing operations.

  • Determine the order in which multiple potential dilutive securities should be considered in computed diluted earnings per share.

  • Determine the order in which multiple potential dilutive securities should be considered in computed diluted earnings per share.


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Earnings per Share Figures for Selected Companies

Basic Diluted Net Income

Company EPS EPS (In millions)

Berkshire Hathaway $521.00 $521.00 $ 795

H. J. Heinz 1.37 1.36 478

Oracle 0.46 0.44 2.561

Microsoft 1.38 1.32 7,346

Wal-Mart 1.49 1.49 6,671


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Simple and Complex Capital Structures

  • Dilutive Securities: Securities whose assumed exercise or conversion results in a reduction in earnings per share.

  • Antidilutive Securities:Securities whose assumed conversion or exercise results in an increase in earnings per share.


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Simple and Complex Capital Structures

Basic

Diluted

Considers only

common shares issued and

outstanding.

Reflects the maximum potential dilution from all possible stock conversions that would have decreased EPS.


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Capital Structures

Complex Capital Structure: The corporation has one or more instruments outstanding that could result in issuance of additional common shares.

Simple Capital Structure: The corporation has only common and nonconvertible preferred stock and has no convertible securities, stock options, warrants, or other rights outstanding.

Therefore, a company with potential per share dilution is considered to have a complex capital structure.


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Basic Earnings Per Share

The Basic Equation:

Net Income – Preferred Dividend

Weighted-Average

Common Shares Outstanding

The Complications:

  • Issuance or reacquisition of common stock

  • Stock dividends or stock splits


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Basic Earnings Per Share

Weighted-Average Number of Shares

Shares Outstanding January 1: 10,000

New Shares Issued May 1: 5,000

Shares Repurchased November 1: 2,000

Continued


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Basic Earnings Per Share

Weighted-Average Number of Shares

Jan. 1 to May 1 10,000 x 4/12 = 3,333

May 1 to Nov. 1 15,000 x 6/12 = 7,500

Nov. 1 to Dec. 31 13,000 x 2/12 = 2,167

Dec. 31 Weighted-average shares 13,000


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Stock Dividends and Stock Splits

Shares outstanding January 1: 2,600

  • Shares issued for exercise

    of options on February 1: 400

  • Shares issued for 10% stock

    dividend on May 1: 300

  • Shares sold for cash on September 1: 1,200

  • Shares repurchased on November 1: 400

  • Shares issued for 3-for-1 stock split on December 15: 8,200

Continued


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Stock Dividends and Stock Splits

No. of Stock Stock Portion of Weighted

DateSharesDividendSplitYearAverage

1/1 to 2/1 2,600

2/1 Option 400

2/1 to 5/1 3,000


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Stock Dividends and Stock Splits

No. of Stock Stock Portion of Weighted

DateSharesDividendSplitYearAverage

1/1 to 2/1 2,600 x 1.10

2/1 Option 400

2/1 to 5/1 3,000 x 1.10

5/1 Dividend 300

5/1 to 9/1 3,300


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Stock Dividends and Stock Splits

No. of Stock Stock Portion of Weighted

DateSharesDividendSplitYearAverage

1/1 to 2/1 2,600 x 1.10

2/1 Option 400

2/1 to 5/1 3,000 x 1.10

5/1 Dividend 300

5/1 to 9/1 3,300

9/1 Sale 1,200

9/1 to 11/1 4,500


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Stock Dividends and Stock Splits

No. of Stock Stock Portion of Weighted

DateSharesDividendSplitYearAverage

1/1 to 2/1 2,600 x 1.10

2/1 Option 400

2/1 to 5/1 3,000 x 1.10

5/1 Dividend 300

5/1 to 9/1 3,300

9/1 Sale 1,200

9/1 to 11/1 4,500

11/1 Purchase (400 )

11/1 to 12/1 4,100


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Stock Dividends and Stock Splits

No. of Stock Stock Portion of Weighted

DateSharesDividendSplitYearAverage

1/1 to 2/1 2,600 x 1.10

2/1 Option 400

2/1 to 5/1 3,000 x 1.10

5/1 Dividend 300

5/1 to 9/1 3,300

9/1 Sale 1,200

9/1 to 11/1 4,500

11/1 Purchase (400 )

11/1 to 12/1 4,100

12/1 Split 8,200

12/1 to 12/31 12,300


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Stock Dividends and Stock Splits

No. of Stock Stock Portion of Weighted

DateSharesDividendSplitYearAverage

1/1 to 2/1 2,600 x 1.10 x 3.0

2/1 Option 400

2/1 to 5/1 3,000 x 1.10 x 3.0

5/1 Dividend 300

5/1 to 9/1 3,300 x 3.0

9/1 Sale 1,200

9/1 to 11/1 4,500 x 3.0

11/1 Purchase (400 )

11/1 to 12/1 4,100 x 3.0

12/1 Split 8,200

12/1 to 12/31 12,300


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Stock Dividends and Stock Splits

No. of Stock Stock Portion of Weighted

DateSharesDividendSplitYearAverage

1/1 to 2/1 2,600 x 1.10 x 3.0 x 1/12 = 715

2/1 Option 400

2/1 to 5/1 3,000 x 1.10 x 3.0 x 3/12 = 2,475

5/1 Dividend 300

5/1 to 9/1 3,300 x 3.0 x 4/12 = 3,300

9/1 Sale 1,200

9/1 to 11/1 4,500 x 3.0 x 2/12 = 2,250

11/1 Purchase (400 )

11/1 to 12/1 4,100 x 3.0x 1/12 = 1,025

12/1 Split 8,200

12/1 to 12/31 12,300 x 1/12 = 1,025


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Stock Dividends and Stock Splits

The weighted-average shares outstanding is 10,790 (the sum of the weighted-average column).

No. of Stock Stock Portion of Weighted

DateSharesDividendSplitYearAverage

1/1 to 2/1 2,600 x 1.10 x 3.0 x 1/12 = 715

2/1 Option 400

2/1 to 5/1 3,000 x 1.10 x 3.0 x 3/12 = 2,475

5/1 Dividend 300

5/1 to 9/1 3,300 x 3.0 x 4/12 = 3,300

9/1 Sale 1,200

9/1 to 11/1 4,500 x 3.0 x 2/12 = 2,250

11/1 Purchase (400 )

11/1 to 12/1 4,100 x 3.0x 1/12 = 1,025

12/1 Split 8,200

12/1 to 12/31 12,300 x 1/12 = 1,025


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Stock Dividends and Stock Splits

  • This must done for all periods presented in the financial statements.

  • All stock splits and stock dividends must be incorporated into the computation of weighted average shares outstanding.

  • Current EPS figures may have to be changed in the future as a result of stock splits or dividends.


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Preferred Stock Included in Capital Structure

Basic EPS reflects only income available to common stockholders; it does not include preferred stock.

To illustrate a simple capital structure for two years, assume the following data:

  • On December 31, 2003, the firm had 10,000 shares of preferred stock and 200,000 shares of common stock outstanding.

  • On June 30, 2004, issued 100,000 shares of common stock.

Continued


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Preferred Stock Included in Capital Structure

No. of Stock Portion of Weighted

DateSharesDividendYearAverage

1/1 to 6/30/04 200,000 x 6/12 100,000

Continued


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Preferred Stock Included in Capital Structure

On June 30, 2004, the firm paid an 8% dividend on preferred stock ($80,000) and a $0.30 per share dividend on common stock (300,000 shares x $0.30 = $90,000). No additional stocks were issued during 2004.

  • These cash dividends would not affect the weighted-average number of shares of common stock; however, Retained Earningswould decrease by $170,000.

Continued


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Preferred Stock Included in Capital Structure

250,000

No. of Stock Portion of Weighted

DateSharesDividendYearAverage

1/1 to 6/30/04 200,000 x 6/12 100,000

7/1 to 12/31/04 300,000 x 6/12 150,000

There are 250,000 weighted-average shares outstanding in 2004

Continued


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Preferred Stock Included in Capital Structure

On May 1, 2005, the firm issued a 50% stock dividend on common stock.

Continued


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Preferred Stock Included in Capital Structure

250,000

No. of Stock Portion of Weighted

DateSharesDividendYearAverage

1/1 to 6/30/04 200,000 x 6/12 100,000

7/1 to 12/31/04 300,000 x 6/12 150,000

1/1 to 4/30/05 300,000 x 4/12 100,000

The weight-average beforeconsidering the stock dividend. The stock dividend was the only stock transaction for 2005.

Continued


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Preferred Stock Included in Capital Structure

250,000

No. of Stock Portion of Weighted

DateSharesDividendYearAverage

1/1 to 6/30/04 200,000 x 6/12 100,000

7/1 to 12/31/04 300,000 x 6/12 150,000

1/1 to 4/30/05 300,000 x 4/12 100,000

5/1 to 12/31/05 450,000 x 8/12 300,000

300,000 x 1.5

WAIT! We are not finished. The stock dividend must be “rolled back” for all years displayed.

Continued


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Preferred Stock Included in Capital Structure

250,000

450,000

No. of Stock Portion of Weighted

DateSharesDividendYearAverage

1/1 to 6/30/04 200,000 x 6/12 100,000

7/1 to 12/31/04 300,000 x 6/12 150,000

x 1.5

150,000

x 1.5

225,000

375,000

1/1 to 4/30/05 300,000 x 4/12 100,000

5/1 to 12/31/05 450,000 x 8/12 300,000

x 1.5

150,000

Continued


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Preferred Stock Included in Capital Structure

Now the EPS for 2004 and 2005 can be calculated for the 2005 income statement.

Assume that in 2004 the firm made a net income, including a $75,000 extraordinary gain, of $380,000.

Continued


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Preferred Stock Included in Capital Structure

Basic earnings per common share, continuing operations (2004):

$305,000

Net income after EI

– $80,000

– Preferred Dividends

375,000 shares of

Weighted-average shares of common stock outstanding

Earnings per share from continuing operations = $0.60

Continued


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Preferred Stock Included in Capital Structure

Basic earnings per common share, extraordinary gain (2004):

$75,000

Extraordinary gain

375,000 shares of

Weighted-average shares of common stock outstanding

Earnings per share from extraordinary gain = $0.20

Continued


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Preferred Stock Included in Capital Structure

Basic earnings per common share: net income per share (2004):

Net income after EI – Preferred Dividend

$380,000 – $80,000

375,000 shares of

Weighted-average shares of common stock outstanding

Earnings per share from extraordinary gain = $0.80

Continued


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Preferred Stock Included in Capital Structure

Assume that in 2005 the firm had a net loss of $55,000 and that there were no extraordinary items.

Basic earnings per common share, continuing operations (2005):

Net loss + Preferred Dividends

$55,000 + $80,000

450,000 shares of

Weighted-average shares of common stock outstanding

Basic loss per share = $(0.30)


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Preferred Stock Included in Capital Structure

Basic earnings per common share, continuing operations (2005):

Net loss + Preferred Dividends

$55,000 + $80,000

Note that a loss is added .

Preferred dividends are included even though they were not declared.

450,000 shares of

Weighted-average shares of common stock outstanding

Basic loss per share = $(0.30)


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Diluted Earnings Per Share—Options, Warrants, and Rights

Dilution occurs if inclusion of a potentially dilutive security reduces the basic EPS or increases the basic loss per share.


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Diluted Earnings Per Share—Options, Warrants, and Rights

  • Proceeds from conversion are assumed to be used for purchase of treasury stock at current market price.

  • Treasury stock is assumed to be reissued to option or warrant holders.

  • Any additional shares issued, over treasury stock, are added to “weighted- average shares outstanding.”

  • Exercise is assumed to occur on the first day of the year unless issue date is later.


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Diluted Earnings Per Share—Options, Warrants, and Rights

  • Number of shares of common stock

    made available to employees 5,000

  • Average market price of stock per

    share during the year $50

  • Exercise price per share on options $40

Number of shares sold 5,000

Proceeds from sale (5,000 x $40) = $200,000

Number of shares that could be

purchased with the proceeds

($200,000 ÷ $50) 4,000

Number of shares used for diluted EPS 1,000


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Diluted Earnings Per Share—Options, Warrants, and Rights

Rasband Corporation had net income for the year of $92,800. There were 100,000 shares of common stock outstanding all year. There are 20,000 options outstanding to purchase shares.

Continued


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Diluted Earnings Per Share—Options, Warrants, and Rights

$92,800

100,000

= $0.93

Basic EPS =

The exercise price per share is $6 and the average market price during the year was $10. The firm had a net income of $92,800 and there were 100,000 shares outstanding throughout the year.

Continued


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Diluted Earnings Per Share—Options, Warrants, and Rights

Proceeds from assumed exercise of options

outstanding (20,000 x $6) $120,000

Number of outstanding shares assumed to

be repurchased with proceeds from options

($120,000 ÷ $10) 12,000

Actual number of shares outstanding 100,000

Issued on assumed exercise of options 20,000

Less assumed options repurchased 12,000 8,000

Total 108,000

Number of Shares to be Used in Computing Diluted EPS

Continued


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Diluted Earnings Per Share—Options, Warrants, and Rights

$92,800

108,000

$92,800

100,000

= $0.86

= $0.93

Diluted Earnings per Share:

The diluted EPS is less than the basic EPS, so it is acceptable.

COMPARED TO—

Basic Earnings per Share:


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Diluted Earnings per Share—Convertible Securities

Assume the following:

  • Net income $10,000

  • 10% convertible bonds

    issued 1/1/05 5,000

  • 15% convertible bonds

    issued 7/1/05 2,000

  • Common shares outstanding

    (no changes during year) 10,000

Continued


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Diluted Earnings per Share—Convertible Securities

  • Tax rate 40%

  • Conversion terms:

    • 10% Bonds: 15 common shares per $100 bond

    • 15% Bonds: 20 common shares per $100 bond

Continued


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Diluted Earnings per Share—Convertible Securities

$10,000

10,000

Basic EPS =

Basic EPS =

$1.00

Net income – Preferred dividend

Weighted-average

common shares outstanding

Basic EPS =

Continued


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Diluted Earnings per Share—Convertible Securities

Net income $10,000

Interest savings

10% bond $ 500

15% bond 150

Less: tax effect (260) 390

Adjusted net income $10,390

Continued


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Diluted Earnings per Share—Convertible Securities

Actual shares outstanding 10,000

Incremental Shares:

10% bond ($5,000/$100 x 15) 750

15% bond ($2,000/$100 x 20

x 1/2) 200 950

Total shares assumed issued 10,950

Continued


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Diluted Earnings per Share—Convertible Securities

$10,390

10,950

Diluted EPS =

Diluted EPS =

$0.95

Diluted

EPS

Adjusted Net Income – Preferred Dividend

Total Shares Assumed Issued

=


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Diluted Earnings per Share—Convertible Securities

  • Bonds were not converted, options were not exercised, etc.

  • Continually remind yourself that the events you are considering when computing diluted EPS did not occur.

  • Diluted EPS is providing information as if these events occurred.


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Effect of Actual Exercise or Conversion

Net income for the year $2,300,000

Common shares outstanding at beginning of year 400,000

Options outstanding at beginning of year to purchase equivalent shares 100,000

Proceeds from actual exercise of options on October1, current year $900,000

Market price of common stock at exercise date, October 1 $15.00

Continued


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Effect of Actual Exercise or Conversion

$2,300,000 (from Slide 55)

?

Basic EPS

= $5.41

425,000

Actual number of shares outstanding for full year 400,000

Weighted-average shares issued on October 1 (100,000 x 3/12) 25,000

Weighted-average number of shares for basic EPS 425,000

Continued


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Effect of Actual Exercise or Conversion

$2,300,000 (from Slide 55)

?

Weighted-average number of shares for basic EPS 425,000

Issued (assumed) exercise of options 100,000

Less: assumed repurchase of shares with proceeds ($900,000 ÷ $15) 60,000

Incremental shares 40,000

Weighted-average (40,000 x 9/12) 30,000

Weighted-average 455,000

Diluted EPS

= $5.05

455,000


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Multiple Potentially Dilutive Securities

Now that you have an idea of how basic and diluted EPS is calculated, it’s time to move to a more complex situation.

Carefully walk through the illustration that is related to LO 6 in your textbook. Note the cautions in Slide 61.

Once you feel comfortable with this material, go to the comprehensive illustration in the “Expanded Materials” section.


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Multiple Potentially Dilutive Securities

When we assume conversion of the preferred stock, those dividends must be added back.

Remember that preferred dividends were initially subtracted from income to arrive at income available to common shareholders.

Also remember there is no tax effect associated with dividends.


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Financial Statement Presentation

Firms are also required to provide the following disclosure items in the notes to the financial statements:

1. A reconciliation of both the numerators and the denominators of the basic and diluted EPS computations for income from continuing operations.

2. The effect that preferred dividends have on the EPS computations.

Continued


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Financial Statement Presentation

  • 3. Securities that could potentially dilute basic EPS in the future that were not included in comparative diluted EPS this period because those securities were antidilutive for the current year.

  • Disclosure of transactions that occurred after the period ended but prior to the issuance of financial statements that would have materially affected the number of common shares outstanding or potentially outstanding such as the issuance of stock options.

  • THE END


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