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

1
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.
• 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.

2
Learning Objectives

1. 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.
2. Determine the order in which multiple potential
   dilutive securities should be considered in
   computed diluted earnings per share.
3. Determine the order in which multiple potential
   dilutive securities should be considered in
   computed diluted earnings per share.

3
Earnings per Share Figures for Selected Companies
4
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.

5
Simple and Complex Capital Structures
Diluted
Basic
Reflects the maximum potential dilution from all
possible stock conversions that would have
decreased EPS.
Considers only common shares issued
and outstanding.
6
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 C
ommon 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
9
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
11
Stock Dividends and Stock Splits
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
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 Date
Shares Dividend Split Year
Average
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
13
Stock Dividends and Stock Splits
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
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 Date
Shares Dividend Split Year
Average
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 Date
Shares Dividend Split Year
Average
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 Date
Shares Dividend Split Year
Average
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
17
Stock Dividends and Stock Splits
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
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
3.0 x 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
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
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
3.0 x 1/12 1,025 12/1 Split 8,200 12/1 to
12/31 12,300 x 1/12 1,025
19
Stock Dividends and Stock Splits

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

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

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

20
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
21
Preferred Stock Included in Capital Structure
No. of
Stock Portion of Weighted Date
Shares Dividend
Year Average
1/1 to 6/30/04 200,000 x 6/12 100,000
Continued
22
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 Earnings would decrease
  by 170,000.

Continued
23
Preferred Stock Included in Capital Structure
No. of
Stock Portion of Weighted Date
Shares Dividend
Year Average
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
24
Preferred Stock Included in Capital Structure
On May 1, 2005, the firm issued a 50 stock
dividend on common stock.
Continued
25
Preferred Stock Included in Capital Structure
No. of
Stock Portion of Weighted Date
Shares Dividend
Year Average
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 before considering the stock
dividend. The stock dividend was the only stock
transaction for 2005.
Continued
26
Preferred Stock Included in Capital Structure
No. of
Stock Portion of Weighted Date
Shares Dividend
Year Average
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
No. of
Stock Portion of Weighted Date
Shares Dividend
Year Average
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
29
Preferred Stock Included in Capital Structure
Basic earnings per common share, continuing
operations (2004)
305,000
Net income after EI
80,000
Preferred Dividends
Weighted-average shares of common stock
outstanding
375,000 shares of
Earnings per share from continuing operations
0.60
Continued
30
Preferred Stock Included in Capital Structure
Basic earnings per common share, extraordinary
gain (2004)
Extraordinary gain
75,000
Weighted-average shares of common stock
outstanding
375,000 shares of
Earnings per share from extraordinary gain 0.20
Continued
31
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
32
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
Weighted-average shares of common stock
outstanding
450,000 shares of
Basic loss per share (0.30)
33
Preferred Stock Included in Capital Structure
Basic earnings per common share, continuing
operations (2005)
Net loss Preferred Dividends
55,000 80,000
Preferred dividends are included even though
they were not declared.
Note that a loss is added .
Weighted-average shares of common stock
outstanding
450,000 shares of
Basic loss per share (0.30)
34
Diluted Earnings Per ShareOptions, Warrants, and
Rights
Dilution occurs if inclusion of a potentially
dilutive security reduces the basic EPS or
increases the basic loss per share.
35
Diluted Earnings Per ShareOptions, 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.

36
Diluted Earnings Per ShareOptions, 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
37
Diluted Earnings Per ShareOptions, 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
38
Diluted Earnings Per ShareOptions, Warrants, and
Rights
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
39
Diluted Earnings Per ShareOptions, Warrants, and
Rights
Number of Shares to be Used in Computing Diluted
EPS
Continued
40
Diluted Earnings Per ShareOptions, Warrants, and
Rights
Diluted Earnings per Share
The diluted EPS is less than the basic EPS, so it
is acceptable.
COMPARED TO
Basic Earnings per Share
41
Diluted Earnings per ShareConvertible 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
42
Diluted Earnings per ShareConvertible Securities

• Tax rate 40
• Conversion terms
• 10 Bonds 15 common shares per 100 bond
• 15 Bonds 20 common shares per 100 bond

Continued
43
Diluted Earnings per ShareConvertible Securities
Net income Preferred dividend Weighted-average c
ommon shares outstanding
Basic EPS
Continued
44
Diluted Earnings per ShareConvertible Securities

• Net income 10,000
• Interest savings
• 10 bond 500
• 15 bond 150
• Less tax effect (260) 390
• Adjusted net income 10,390

Continued
45
Diluted Earnings per ShareConvertible 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
46
Diluted Earnings per ShareConvertible Securities
Adjusted Net Income Preferred Dividend Total
Shares Assumed Issued
Diluted EPS

47
Diluted Earnings per ShareConvertible Securities

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

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

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

48
Effect of Actual Exercise or Conversion
Continued
49
Effect of Actual Exercise or Conversion
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
50
Effect of Actual Exercise or Conversion
Diluted EPS
5.05
455,000
51
Multiple Potentially Dilutive Securities
Now that you have an idea of how basic and
diluted EPS is calculated, its 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.
52
Multiple Potentially Dilutive Securities

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

When we assume conversion of the preferred stock,
those dividends must be added back.
Also remember there is no tax effect associated
with dividends.
53
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
54
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