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Chapter 19 - Earnings per Share Learning Objectives

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 Share Learning Objectives

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  1. 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.

  2. 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.

  3. 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

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

  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.

  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

  8. 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

  10. 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 DateSharesDividendSplitYearAverage 1/1 to 2/1 2,600 2/1 Option 400 2/1 to 5/1 3,000

  12. 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

  13. 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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

  19. 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.

  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 DateSharesDividendYearAverage 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 Earningswould decrease by $170,000. Continued

  23. 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

  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 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

  26. 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

  27. 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

  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. 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 375,000 shares of Weighted-average shares of common stock outstanding Earnings per share from continuing operations = $0.60 Continued

  30. 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

  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 + $80,000 450,000 shares of Weighted-average shares of common stock outstanding 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 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)

  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. 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.

  36. 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

  37. 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

  38. 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

  39. 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

  40. 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:

  41. 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

  42. 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

  43. 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

  44. 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

  45. 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

  46. 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 =

  47. 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.

  48. 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

  49. 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

  50. 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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