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ACCT-365 EPS Review Problem

Review problem

• ABC Corporation has Net income for 2001 of $2,000,000 after tax. This income includes Extraordinary gain of $45,000
• On January 1, 2001 the company had 600,000 common shares outstanding
• On May 1, 2001 the company retired 100,000 common shares
• On August 1, 2001 the company had a 3 for 1 stock split
• ABC Corporation has 50,000, $0.80 convertible, cumulative preferred shares outstanding throughout the year and each preferred share is convertible to 2 shares of common stock
• ABC Corporation has $500,000, 9% convertible bonds outstanding throughout the year. They are convertible at 40 shares of common stock per $1000 bond
• The tax rate is 40%
• ABC Corporation has options outstanding to purchase 20,000 common shares for $25 each. The market price of the shares is $32 each

Calculate EPS for ABC Corporation.

Solution:

BASIC EPS

1.     Net income before EIDO

$2,000,000 - $45,000 = $1,955,000

2.     There are cumulative preferred shares. The dividends have to be deducted from Net income

Dividends = 50,000 * $0.80 = $40,000

3.     Weighted average shares

Dates                     Shares              Restatement           Fraction            Weighted

Outstanding         Outstanding                                       of Year             avg. shares

--------------------------------------------------------------------------------------------------------------------

    Jan.1-April 31        600,000               3                      4/12                  600,000

    May 1                      100,000

                                    -----------                                             

    May 1-July 31         500,000               3                      3/12                  375,000

    August 1               1,000,000

                                    -------------                                              

    Aug. 1-Dec. 31     1,500,000                                      5/12                  625,000                                   

                                                                                                                      ------------

                                                                                                                   1,600,000                                

 

4.     Basic EPS before EIDO

Basic EPS before EIDO = [Net Income before EIDO - Dividends (PS)] / Weighted average shares

Basic EPS before EIDO = ($1,955,000 - $40,000) / 1,600,000

=$1,915,000 / 1,600,000 = 1.197

5.     Extraordinary gain

EPS = Extraordinary gain / Weighted average shares

EPS = $45,000 / 1,600,000 = 0.028

6.    Basic EPS

       Basic EPS:

       Income before EIDO                      1.197

       Extraordinary gain                          0.028

                                                                 ---------

       Basic EPS                                        1.225

 

DILUTIVE EPS

1.     Cumulative preferred shares

Assume conversion. If the stock is converted the company would have to issue an additional 100,000    shares of common stock (50,000 * 2). As a result the WASO would increase to 1,700,000.

Since the preferred dividend would no longer be issued the company would not have to pay $40,000 dividends (50,000 * 0.08). Since dividends are not tax deductible, there are no tax implications. So the company would have generated an additional $40,000 in net income attributable to common stockholders.

IF METHOD TEST

Dividends / # shares convertible into

$40,000 / 100,000 = 0.4

0.4 < 1.197

The preferred shares are dilutive and they have to be included in the calculation of EPS.

2.     Convertible bonds

Assume conversion. If the bonds are converted, the company would have to issue an additional 20,000 (500,000 / 1,000 * 40) shares of common stock. As a result the WASO would increase to 1,720,000.

Since the debt would be converted, no interest would have to be paid. Interest was $45,000 per annum (500,000 * 0.09). So net of taxes the company would have generated an additional $27,000 [(45,000 * (1-0.40)] in net income.

IF METHOD TEST

Interest Expense * (1 - Tax rate) / # shares convertible into

$27,000 / 20,000 = 1.35

1.35 > 1.197

The bonds are anti-dilutive and they have to be excluded from the calculation of EPS.

3.     Options

TREASURY METHOD

a. Calculate the amount raised through the exercise of options:

20,000 * $25 = $500,000

b. Calculate the number of common shares that can be repurchased using the amount raised through the exercise of options (found in step #1):

$500,000 / $32 = 15,625

Since the market provides less shares the options are dilutive

c. Find the net number by which the number of the stock options exercised exceeds the number of common shares repurchased at the market price and add the difference to WASO. 

                                                                20,000 - 15,625 = 4,375

 

4.     Fully dilutive EPS before EIDO

($1,915,000 + $40,000) / (1,600,000 + 100,000 + 4,375) = 1.147

 

5.     Extraordinary gain

$45,000 / (1,600,000 + 100,000 + 4,375) = 0.026

6.    Fully dilutive EPS

       Fully dilutive EPS:

       Income before EIDO                       1.147

       Extraordinary gain                           0.026

                                                                  ---------

       Fully dilutive EPS                            1.173

 

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