The Simon Corporation issued 10-year, $4,440,000 par, 7% callable convertible subordinated debentures on January 2, 2020. The bonds have a par value of $1,000, with interest payable annually. The current conversion ratio is 14:1, and in 2 years it will increase to 16:1. At the issuance date, the bonds were sold at 98. Bond discount is amortized on a straight-line basis. Simon’s effective tax rate was 35%. Net income in 2014 was $ 9,500,000, and the company had 2,000,000 shares outstanding during the entire year.
Instructions:
(a) Prepare a schedule to compute both basic and diluted earnings per share.
(b) Discuss how the schedule would differ if the security was convertible preferred stock.

Solution:

(a) Net income for year                                                      $9,500,000

Add: Adjustment for interest (net of tax)                              234,000 *

                                                                                           $9,734,000

*Maturity value                                                                  $4,440,000

Stated rate                                                                                    X 7%

Cash interest                                                                          350,000

Discount amortization [(1.00 – .98) X $4,440,000X 1/10]     10,000

Interest expense                                                                    360,000

1 – tax rate (35%)                                                                         X .65

After-tax interest $234,000 $4,440,000X /$1,000 = 5,000 debentures

Increase in diluted earnings per share denominator: 5,000 x 18=90,000

Earnings per share: Basic EPS $9,500,000 ÷ 2,000,000 = $4.75

Diluted EPS $9,734,000 ÷ 2,090,000 = $4.66

(b) If the convertible security were preferred stock, basic EPS would be the same assuming there were no preferred dividends declared or the preferred was noncumulative. For diluted EPS, the numerator would be the net income amount and the denominator would be 2,090,000.

DILUTIVE SECURITIES AND EARNINGS PER SHARE (cont.)

Any shares may be "antidilutive." In other words, if the above-mentioned laws are translated and implemented, the EPS will increase.  

Net profit of 10 000 USD and 50 000 non-weighted-average outstanding shares can be never considered to be transferred to anti-dilutive securities when measuring diluted EPS. Odd Co. also had outstanding $100,000 convertible bonds. Such bonds were sold in cash, are 10 percent interest payable and can be exchanged into 5,000 common stock shares. The tax rate of Odd Co.'s is 40%.

In the calculification of Diluted EPS the convertible bonds can not be expected to be converted. In the event of a conversion, the net revenue would be increased by $6,000 (same as $10,000x (1-40%). Shares are projected to rise by 5,000. That will boost EPS from $0.20 to $10,000 and 50,000 to $0.29 per share (equal to ($10,000+$6,000)/(50,000 + 5,000)).

If a corporation has several types of dilutive shares, the per share effect is based on the EPS of each class. Securities classes are then graded to be the most dilutive class. The investment class that lowers the EPS most is expected to be transformed in the first place, the class that lowers the EPS to the next largest, etc.

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