Answer:
Part A:
1. Computation of Basic EPS
Basic EPS = (Net Income - Preferred Dividends) / Weighted Average Shares Outstanding²
Net Income = $120,000
Preferred Dividends = 4% x $50,000 = $2,000
Weighted Average Shares Outstanding = 100,000 (assuming no change in common stock during the year)
Basic EPS = ($120,000 - $2,000) / 100,000
Basic EPS = $1.18
2. Individual dilution/anti-dilution with decision making
We need to check if any of the convertible securities or stock options are dilutive or anti-dilutive by comparing their impact on EPS with the basic EPS.
Convertible Preferred: Each preferred share can be converted into 1.9 common shares (1,900 / 1,000). The conversion would increase the common shares outstanding by 1,900 and decrease the preferred dividends by $2,000.
EPS after conversion = ($120,000 - $0) / (100,000 + 1,900)
EPS after conversion = $1.16
Since this is lower than the basic EPS of $1.18, the convertible preferred is dilutive and should be included in the diluted EPS calculation.
Stock Options - A: Each option can be exercised at $12 to buy one common share when the average market price is $11. This means that the options are out of the money and would not be exercised by the holders. Therefore, they have no impact on EPS and are anti-dilutive.
Stock Options - B: Each option can be exercised at $7 to buy one common share when the average market price is $8. This means that the options are in the money and would be exercised by the holders. The exercise would increase the common shares outstanding by 4,000 and generate cash proceeds of $28,000 ($7 x 4,000). The cash proceeds can be used to buy back some common shares at the market price of $8. The number of shares bought back is 3,500 ($28,000 / $8). The net increase in common shares outstanding is 500 (4,000 - 3,500).
EPS after exercise = ($120,000 - $2,000) / (100,000 + 500)
EPS after exercise = $1.17
Since this is lower than the basic EPS of $1.18, the stock options - B are dilutive and should be included in the diluted EPS calculation.
Convertible Bonds: Each bond can be converted into 40 common shares (40,000 / 1,000). The conversion would increase the common shares outstanding by 40,000 and decrease the interest expense by $50,000 ($1,000,000 x 5%). The interest expense is net of tax, so we need to multiply it by (1 - tax rate) to get the after-tax amount. The tax rate is 30%.
EPS after conversion = ($120,000 - $2,000 + $50,000 x (1 - 0.3)) / (100,000 + 40,000)
EPS after conversion = $1.19
Since this is higher than the basic EPS of $1.18, the convertible bonds are anti-dilutive and should be excluded from the diluted EPS calculation.
3. Ranking of potential dilutors
We need to rank the potential dilutors from the most dilutive to the least dilutive based on their impact on EPS.
The most dilutive security is the convertible preferred with an EPS of $1.16.
The second most dilutive security is the stock options - B with an EPS of $1.17.
The least dilutive security is the convertible bonds with an EPS of $1.19.
4. Step-by-step inclusion of individual dilutors to arrive at reportable EPS with decision making.
We need to include the potential dilutors in order of their dilution until we reach a point where the next security would be anti-dilutive.
The first security to include is the convertible preferred.
EPS with convertible preferred = ($120,000 - $0) / (100,000 + 1,900)
EPS with convertible preferred = $1.16
The next security to include is the stock options - B.
EPS with stock options - B = ($120,000 - $0) / (100,000 + 1,900 + 500)
EPS with stock options