Question

On January 1, 2021, Tonge Industrles had outstanding 840,000 common shares ( $1 par) that orlginally sold for $30 per share, and 5,000 shares of 10% cumulative preferred stock (\$100 par). convertible Into 50,000 common shares. On October 1, 2021, Tonge sold and Issued an additional 16,000 shares of common stock at $40. At December 31, 2021, there were 25,000 incentive stock optlons outstanding, Issued In 2020, and exerclsable after one year for 25,000 shares of common stock at an exercise price of $40. The market price of the common stock at year-end was $58. Durling the year, the price of the common shares had averaged $50 Net Income was $980,000. The tax rate for the year was 25%. Required: Compute basic and diluted EPS for the year ended December 31, 2021. (Enter your answers in thousands (l.e., 100,000 should be entered as 100). Round "Earnings per share" answers to 2 decimal places.)

Answer 1

To compute both basic and diluted earnings per share (EPS), we need to consider the effects of the common shares, preferred shares, and stock options on the net income for the year ended December 31, 2021.

Here are the steps to calculate both basic and diluted EPS:

Step 1: Calculate the weighted average number of common shares outstanding for basic EPS.

Weighted average common shares outstanding at the beginning of the year (January 1, 2021): 840,000

Weighted average common shares issued on October 1, 2021: 16,000

Weighted average common shares for basic EPS = (840,000 * 9/12) + (16,000 * 3/12) = 630,000 + 4,000 = 634,000

Step 2: Calculate the weighted average number of common shares for diluted EPS.

To calculate the diluted EPS, we need to consider the conversion of preferred shares and the exercise of stock options.

Convertible preferred shares:

Preferred shares convertible into common shares = 5,000 shares

Conversion ratio = 50,000 common shares / 5,000 preferred shares = 10 common shares per preferred share

We need to check if the conversion of preferred shares would dilute EPS. To do this, we compare the average market price of common shares ($50) to the conversion price of preferred shares ($100). Since the market price is lower than the conversion price, we don't consider the conversion of preferred shares in the diluted EPS calculation.

Stock options:

Incentive stock options exercisable for common shares = 25,000 options

We calculate the dilutive effect of stock options using the treasury stock method. The average market price of common shares is $50, and the exercise price of stock options is $40.

The difference between the market price and exercise price is $50 - $40 = $10 per share.

Number of additional common shares (treasury shares) assumed to be bought back at the average market price using the proceeds from the exercise of stock options = (25,000 * $10) / $50 = 5,000 shares

Weighted average common shares for diluted EPS = Weighted average common shares for basic EPS + Treasury shares from stock options = 634,000 + 5,000 = 639,000

Step 3: Calculate earnings before preferred dividends and taxes.

Net Income = $980,000

Preferred Dividends (10,000 preferred shares * $100 * 10%): $100,000

Earnings before taxes and preferred dividends = $980,000 + $100,000 = $1,080,000

Step 4: Calculate earnings available for common shareholders.

Earnings available for common shareholders = Earnings before taxes and preferred dividends - Taxes

Taxes = ($1,080,000 * 25%) = $270,000

Earnings available for common shareholders = $1,080,000 - $270,000 = $810,000

Step 5: Calculate basic and diluted EPS.

Basic EPS = Earnings available for common shareholders / Weighted average common shares for basic EPS

Diluted EPS = Earnings available for common shareholders / Weighted average common shares for diluted EPS

Basic EPS = $810,000 / 634,000 = $1.28 per share

Diluted EPS = $810,000 / 639,000 = $1.27 per share

So, the basic EPS for the year ended December 31, 2021, is $1.28 per share, and the diluted EPS is $1.27 per share.