1. 1 1. Know the difference between a simple and a complex capital structure, and understand how dilutive securities affect earnings per share computations. 2. 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. 3. 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. Chapter 19 - Earnings per Share Chapter 19 - Earnings per Share Learning Objectives

2. 2 Learning Objectives 5. 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. 6. Determine the order in which multiple potential dilutive securities should be considered in computed diluted earnings per share. 7. Determine the order in which multiple potential dilutive securities should be considered in computed diluted earnings per share.

3. 3 Earnings per Share Figures for Selected Companies Basic Diluted Net Income Basic Diluted Net Income Company EPS EPS (In millions) Berkshire Hathaway$521.00$521.00$ 795 H. J. Heinz1.371.36478 Oracle0.460.442.561 Microsoft1.381.327,346 Wal-Mart1.491.496,671

4. 4 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. Simple and Complex Capital Structures

5. 5 Reflects the maximum potential dilution from all possible stock conversions that would have decreased EPS. Diluted Simple and Complex Capital Structures Considers only common shares issued and outstanding. Basic

6. 6 Capital Structures Simple Capital Structure: The corporation has only common and nonconvertible preferred stock and has no convertible securities, stock options, warrants, or other rights outstanding. Complex Capital Structure: The corporation has one or more instruments outstanding that could result in issuance of additional common shares. Therefore, a company with potential per share dilution is considered to have a complex capital structure.

7. 7 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 The Complications: –Issuance or reacquisition of common stock –Stock dividends or stock splits

8. 8 Shares Outstanding January 1:10,000 New Shares Issued May 1:5,000 Shares Repurchased November 1: 2,000 Basic Earnings Per Share Weighted-Average Number of Shares ContinuedContinued

9. 9 Jan. 1 to May 110,000 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 shares13,000 Basic Earnings Per Share Weighted-Average Number of Shares

10. 10 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 Stock Dividends and Stock SplitsContinuedContinued

11. 11 1/1 to 2/12,600 2/1 Option 400 2/1 to 5/13,000 No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average Stock Dividends and Stock Splits

12. 12 1/1 to 2/12,600 x 1.10 2/1 Option 400 2/1 to 5/13,000 x 1.10 5/1 Dividend 300 5/1 to 9/13,300 No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average Stock Dividends and Stock Splits

13. 13 1/1 to 2/12,600 x 1.10 2/1 Option 400 2/1 to 5/13,000 x 1.10 5/1 Dividend 300 5/1 to 9/13,300 9/1 Sale1,200 9/1 to 11/14,500 No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average Stock Dividends and Stock Splits

14. 14 1/1 to 2/12,600 x 1.10 2/1 Option 400 2/1 to 5/13,000 x 1.10 5/1 Dividend 300 5/1 to 9/13,300 9/1 Sale1,200 9/1 to 11/14,500 11/1 Purchase (400) 11/1 to 12/14,100 No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average Stock Dividends and Stock Splits

15. 15 1/1 to 2/12,600 x 1.10 2/1 Option 400 2/1 to 5/13,000 x 1.10 5/1 Dividend 300 5/1 to 9/13,300 9/1 Sale1,200 9/1 to 11/14,500 11/1 Purchase (400) 11/1 to 12/14,100 12/1 Split 8,200 12/1 to 12/3112,300 No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average Stock Dividends and Stock Splits

16. 16 1/1 to 2/12,600 x 1.10x 3.0 2/1 Option 400 2/1 to 5/13,000 x 1.10x 3.0 5/1 Dividend 300 5/1 to 9/13,300 x 3.0 9/1 Sale1,200 9/1 to 11/14,500 x 3.0 11/1 Purchase (400) 11/1 to 12/14,100 x 3.0 12/1 Split 8,200 12/1 to 12/3112,300 No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average Stock Dividends and Stock Splits

17. 17 1/1 to 2/12,600 x 1.10x 3.0x 1/12 =715 2/1 Option 400 2/1 to 5/13,000 x 1.10x 3.0x 3/12 =2,475 5/1 Dividend 300 5/1 to 9/13,300 x 3.0x 4/12 =3,300 9/1 Sale1,200 9/1 to 11/14,500 x 3.0x 2/12 =2,250 11/1 Purchase (400) 11/1 to 12/14,100 x 3.0x 1/12 =1,025 12/1 Split 8,200 12/1 to 12/3112,300 x 1/12 =1,025 No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average Stock Dividends and Stock Splits

18. 18 1/1 to 2/12,600 x 1.10x 3.0x 1/12 =715 2/1 Option 400 2/1 to 5/13,000 x 1.10x 3.0x 3/12 =2,475 5/1 Dividend 300 5/1 to 9/13,300 x 3.0x 4/12 =3,300 9/1 Sale1,200 9/1 to 11/14,500 x 3.0x 2/12 =2,250 11/1 Purchase (400) 11/1 to 12/14,100 x 3.0x 1/12 =1,025 12/1 Split 8,200 12/1 to 12/3112,300 x 1/12 =1,025 No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average Stock Dividends and Stock Splits The weighted-average shares outstanding is 10,790 (the sum of the weighted-average column).

19. 19 1.All stock splits and stock dividends must be incorporated into the computation of weighted average shares outstanding. 2.This must done for all periods presented in the financial statements. 3.Current EPS figures may have to be changed in the future as a result of stock splits or dividends. Stock Dividends and Stock Splits

20. 20 Preferred Stock Included in Capital Structure 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. ContinuedContinued Basic EPS reflects only income available to common stockholders; it does not include preferred stock.

21. 21 Preferred Stock Included in Capital Structure 1/1 to 6/30/04200,000x 6/12100,000 No. of Stock Portion of Weighted Date Shares Dividend Year Average ContinuedContinued

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

23. 23 Preferred Stock Included in Capital Structure 1/1 to 6/30/04200,000x 6/12100,000 7/1 to 12/31/04300,000x 6/12150,000 No. of Stock Portion of Weighted Date Shares Dividend Year Average ContinuedContinued There are 250,000 weighted-average shares outstanding in 2004 250,000

24. 24 Preferred Stock Included in Capital Structure On May 1, 2005, the firm issued a 50% stock dividend on common stock. ContinuedContinued

25. 25 Preferred Stock Included in Capital Structure 1/1 to 6/30/04200,000x 6/12100,000 7/1 to 12/31/04300,000x 6/12150,000 No. of Stock Portion of Weighted Date Shares Dividend Year Average 250,000 1/1 to 4/30/05300,000x 4/12100,000 The weight-average before considering the stock dividend. The stock dividend was the only stock transaction for 2005. ContinuedContinued

26. 26 300,000 x 1.5 Preferred Stock Included in Capital Structure 1/1 to 6/30/04200,000x 6/12100,000 7/1 to 12/31/04300,000x 6/12150,000 No. of Stock Portion of Weighted Date Shares Dividend Year Average 250,000 1/1 to 4/30/05300,000x 4/12100,000 5/1 to 12/31/05450,000x 8/12300,000 ContinuedContinued WAIT! We are not finished. The stock dividend must be “rolled back” for all years displayed.

27. 27 Preferred Stock Included in Capital Structure 1/1 to 6/30/04200,000x 6/12100,000 7/1 to 12/31/04300,000x 6/12150,000 250,000 1/1 to 4/30/05300,000x 4/12100,000 5/1 to 12/31/05450,000x 8/12300,000 ContinuedContinued x 1.5150,000 x 1.5 225,000 150,000 No. of Stock Portion of Weighted Date Shares Dividend Year Average 375,000 450,000

28. 28 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. ContinuedContinued

29. 29 Preferred Stock Included in Capital Structure Basic earnings per common share, continuing operations (2004): – Preferred Dividends Weighted-average shares of common stock outstanding – $80,000 375,000 shares of Earnings per share from continuing operations = $0.60 ContinuedContinued Net income after EI $305,000

30. 30 Preferred Stock Included in Capital Structure Basic earnings per common share, extraordinary gain (2004): Weighted-average shares of common stock outstanding 375,000 shares of Earnings per share from extraordinary gain = $0.20 ContinuedContinued Extraordinary gain$75,000

31. 31 Preferred Stock Included in Capital Structure Basic earnings per common share: net income per share (2004): Weighted-average shares of common stock outstanding 375,000 shares of Earnings per share from extraordinary gain = $0.80 ContinuedContinued Net income after EI – Preferred Dividend $380,000 – $80,000

32. 32 Preferred Stock Included in Capital Structure Basic earnings per common share, continuing operations (2005): Net loss + Preferred Dividends Weighted-average shares of common stock outstanding $55,000 + $80,000 450,000 shares of Basic loss per share = $(0.30) Assume that in 2005 the firm had a net loss of $55,000 and that there were no extraordinary items.

33. 33 Preferred Stock Included in Capital Structure Basic earnings per common share, continuing operations (2005): Net loss + Preferred Dividends Weighted-average shares of common stock outstanding $55,000 + $80,000 450,000 shares of Basic loss per share = $(0.30) Preferred dividends are included even though they were not declared. Note that a loss is added.

34. 34 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.

35. 35  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. Diluted Earnings Per Share—Options, Warrants, and Rights

36. 36  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 EPS1,000 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 EPS1,000 Diluted Earnings Per Share—Options, Warrants, and Rights

37. 37 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. ContinuedContinued Diluted Earnings Per Share—Options, Warrants, and Rights

38. 38 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. ContinuedContinued $92,800 100,000 Basic EPS = = $0.93 Diluted Earnings Per Share—Options, Warrants, and Rights

39. 39 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 Number of Shares to be Used in Computing Diluted EPS Actual number of shares outstanding100,000 Issued on assumed exercise of options20,000 Less assumed options repurchased12,000 8,000 Total108,000ContinuedContinued Diluted Earnings Per Share—Options, Warrants, and Rights

40. 40 Diluted Earnings per Share: $92,800 108,000 = $0.86 COMPARED TO— Basic Earnings per Share: $92,800 100,000 = $0.93 The diluted EPS is less than the basic EPS, so it is acceptable. Diluted Earnings Per Share—Options, Warrants, and Rights

41. 41 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 Diluted Earnings per Share— Convertible SecuritiesContinuedContinued

42. 42 –Tax rate 40% –Conversion terms: 10% Bonds: 15 common shares per $100 bond 15% Bonds: 20 common shares per $100 bond Diluted Earnings per Share— Convertible SecuritiesContinuedContinued

43. 43 Net income – Preferred dividend Weighted-average common shares outstanding Basic EPS = $10,000 10,000 $1.00Basic EPS = Diluted Earnings per Share— Convertible SecuritiesContinuedContinued

44. 44 Net income$10,000 Interest savings 10% bond$ 500 15% bond 150 Less: tax effect (260) 390 Adjusted net income$10,390 Diluted Earnings per Share— Convertible SecuritiesContinuedContinued

45. 45 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 Diluted Earnings per Share— Convertible SecuritiesContinuedContinued

46. 46 Adjusted Net Income – Preferred Dividend Total Shares Assumed Issued Diluted EPS Diluted EPS = $10,390 10,950 = $0.95Diluted EPS = Diluted Earnings per Share— Convertible Securities

47. 47 Diluted Earnings per Share— Convertible Securities 1.Continually remind yourself that the events you are considering when computing diluted EPS did not occur. 2.Bonds were not converted, options were not exercised, etc. 3.Diluted EPS is providing information as if these events occurred.

48. 48 Effect of Actual Exercise or Conversion Net income for the year$2,300,000 Common shares outstanding at beginning of year400,000 Options outstanding at beginning of year to purchase equivalent shares100,000 Proceeds from actual exercise of options on October1, current year$900,000 Market price of common stock at exercise date, October 1$15.00ContinuedContinued

49. 49 Effect of Actual Exercise or Conversion Basic EPS $2,300,000 (from Slide 55) ? Actual number of shares outstanding for full year400,000 Weighted-average shares issued on October 1 (100,000 x 3/12) 25,000 Weighted-average number of shares for basic EPS425,000 425,000 = $5.41 ContinuedContinued

50. 50 Effect of Actual Exercise or Conversion Diluted EPS $2,300,000 (from Slide 55) ? = $5.05 455,000 Weighted-average number of shares for basic EPS425,000 Issued (assumed) exercise of options100,000 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-average455,000

51. 51 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.

52. 52 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. Multiple Potentially Dilutive Securities

53. 53 Financial Statement Presentation 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. Firms are also required to provide the following disclosure items in the notes to the financial statements: Continued

54. 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. 4.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