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Int. Acc. FA LECT 5&6: CH 16 part 7: Dilutive securities and EPS (EPS…
Int. Acc. FA LECT 5&6: CH 16 part 7: Dilutive securities and EPS
Compute EPS in a complex capital structure.
Complex Capital Structure exists when a business has
--> convertible securities,
--> options,warrants,or other rights
that upon conversion or exercise could dilute earnings per share.
Company reports both basic and diluted earnings per share.
Diluted EPS includes the effect of all potential dilutive ordinary
shares that were outstanding during the period.
Companies will not report diluted EPS if the securities in their capital structure are antidilutive. (Only interested in worst-case scenarios.)
EPS-complex capital structure (II)
Measure the dilutive effects of potential conversion on EPS using the
if-converted method
.
This method for a convertible bond assumes:
(1) the conversion at the beginning of the period (or at the time of issuance of the security, if issued during the period), and
(2) the elimination of related interest, net of tax.
(1) Affects the denominator
(2) Affects the numerator
EPS-complex capital structure (III)
When calculating Diluted EPS, begin with Basic EPS.
What would happen if shares are converted: Number of shares outstanding would increase.
What would happen if shares are converted:
Interest payments on bonds wouldn’t have to be paid: so net
income would be higher
Example 1: EPS with Preference Shares
EPS-complex capital structure (IV)
Example 2: EPS with options and warrants
Measure the dilutive effects of potential conversion using the
treasury-share method
.
This method assumes:
Options/warrants are exercised at the beginning of the year (or date of issue if later), and
Company uses those proceeds to purchase ordinary shares for the treasury.
Simply put
Exercise warrant or not?
Yes! Purchase something worth $30 for $10.
Treasury method: proceeds of 3x$10 are used to repurchase shares.
1 share can be repurchased (FV = $30).
3 warrants, strike price of $10. FV of share in the market = $30.
Net effect of warrant exercise: 2 new shares outstanding
3 new shares outstanding due to exercising the warrant, but 1 share is repurchased.