Chapter 16, Problem 23P

1.

To determine

Compute the basic earnings per share for Company M.

Explanation of Solution

Earnings per share (EPS):

The amount of net income available to each shareholder per common share outstanding is referred to as earnings per share (EPS).

Compute the basic earnings per share for Company M.

$\begin{array}{c}\text{Basic earnings per share =}\frac{\text{Net income}-\text{Preferred dividend}}{\left(\begin{array}{l}\text{Weighted Average number of}\\ \text{ common shares outstanding}(1)\end{array}\right)}\\ =\frac{\$575,000-\$60,000\left(5,000\times \$100\times 12\%\right)}{\$264,164}\\ =\frac{\$515,000}{\$264,164}\\ =\$1.95\end{array}$

Working notes:

(1) Calculation of weighted average shares outstanding:

(Figure 1)

2.

To determine

Compute the tentative and incremental dilutive earnings per share for each dilutive security.

Explanation of Solution

Compute tentative diluted EPS for stock options.

$\begin{array}{c}\begin{array}{l}\text{Tentative diluted EPS }\\ \text{for stock options}\end{array}\}\text{ = }\frac{\text{Net income –Preferred dividends}}{\left(\begin{array}{l}\text{Weighted average number }\\ \text{of common shares outstanding}\end{array}\right)}\\ \text{= }\frac{\text{\$575,000 – \$60,000}}{\text{275,068 shares (3)}}\\ \text{= \$1}\text{.87 per share}\end{array}$

Compute the incremental diluted EPS for stock options.

$\begin{array}{c}\begin{array}{l}\text{Incremental }\\ \text{diluted EPS}\end{array}\}\text{ = }\frac{\text{Increase in EPS numerator}}{\text{Increase in EPS denominator}}\\ \text{=}\frac{\text{Increase in EPS numerator}}{\text{Increase in number of common shares}}\\ \text{=}\frac{\text{\$0}}{\left(\text{275,068–264,167}\right)\text{ common shares}}\\ =\$0\end{array}$            

Compute the incremental diluted EPS for convertible bonds.

$\begin{array}{c}\begin{array}{l}\text{Incremental diluted EPS }\\ \text{for convertible bonds}\end{array}\}\text{ = }\frac{\text{Increase in EPS numerator}\left(4\right)}{\text{Increase in EPS denominator}\left(5\right)}\\ \text{=}\frac{\left(\begin{array}{l}\text{Increase in EPS due to decrease }\\ \text{in interest expense, net of taxes}\end{array}\right)}{\text{Increase in number of common shares}}\\ \text{=}\frac{\text{\$34,560}}{\text{19,200 common shares}}\\ =\$1.80\end{array}$         

Compute the incremental diluted EPS of convertible preferred stock.

$\begin{array}{c}\begin{array}{l}\text{Incremental diluted }\\ \text{EPS of convertible }\\ \text{preferred stock}\end{array}\}\text{ = }\frac{\text{Increase in EPS numerator}}{\text{Increase in EPS denominator}\left(6\right) }\\ \text{=}\frac{\left(\begin{array}{l}\text{Increase in numerator due to }\\ \text{decrease in preferred dividend}\end{array}\right)}{\text{Increase in number of common shares}}\\ \text{=}\frac{\text{\$60,000}}{\text{75,000 common shares}}\\ =\$0.08\end{array}$        

Compute tentative diluted EPS assuming for 12% convertible preferred stock.

$\begin{array}{c}\begin{array}{l}\text{Tentative }\\ \text{diluted EPS }\end{array}\}\text{= }\frac{\left(\text{Net income –Preferred dividends}\right)\text{+Preferred dividend}s}{\text{Weighted average number of common shares outstanding}}\\ \text{= }\frac{\text{\$575,000 –\$60,000+ \$60,000}}{\text{275,068 shares+75,000 shares}}\\ =\frac{\text{\$575,000}}{\text{350,068 shares}}\\ \text{= \$1}\text{.64 per share}\end{array}$

Compute tentative diluted EPS assuming, exercisable options, 9% convertible bonds, and 12% convertible preferred stock.

$\begin{array}{c}\text{Diluted EPS = }\frac{\left\{\begin{array}{l}\left(\text{Net income –Preferred dividends}\right)\text{+}\\ \text{Preferred dividend}s\text{+After-tax interest savings}\end{array}\right\}}{\text{Weighted average number of common shares outstanding}}\\ \text{= }\frac{\text{\$575,000 –\$60,000+ \$60,000+\$34,560}}{\text{275,068 shares+75,000 shares+19,200 shares}}\\ =\frac{\text{\$609,560}}{\text{369,268 shares}}\\ \text{= \$1}\text{.65 per share}\end{array}$

Working notes:

(1) Calculate the value of exercisable options:

$\begin{array}{c}\text{Exercisable options value = Number of shares × Exercise price}\\ \text{= 22,000 shares × \$15}\\ \text{= \$330,000}\end{array}$

(2) Compute the number of shares required:

$\begin{array}{c}\begin{array}{l}\text{Number of shares }\\ \text{assumed reacquired}\end{array}\}\text{ = }\frac{\text{Exercisable options}}{\text{Average market price per share}}\\ \text{= }\frac{\text{\$330,000 (1)}}{\text{\$37}}\\ \text{= 8,919 shares }\end{array}$

(3) Compute the total weighted average number of common shares.

(Figure 2)

(4) Compute the amount of interest expense, net of income tax on 9% bonds.

$\begin{array}{c}\begin{array}{l}\text{Interest expense, }\\ \text{net of taxes}\end{array}\}=\left(\begin{array}{l}\text{Face value of bonds ×}\\ \text{Stated interest rate}\end{array}\right)\text{×}\left(\text{1–Income tax rate}\right)\\ =\left(\$600\text{,000×9\%}\right)\times \left(1–0.36\right)\\ \text{=\$54,000}\times \text{0}\text{.64}\\ \text{=\$34,560}\end{array}$     

(5) Compute the number of common shares due to conversion of 9% bonds.

$\begin{array}{c}\text{Numbre of common shares}=\left\{\begin{array}{l}\text{Number of convertible bonds}\times \\ \text{Conversion rate}\end{array}\right\}\\ =\frac{\$600\text{,000}}{\$1,000}\text{×32 shares}\\ \text{= 19,200 shares}\end{array}$                

(6) Compute the number of common shares due to conversion of preferred shares.

$\begin{array}{c}\text{Numbre of common shares}=\left\{\begin{array}{l}\text{Number of preferred shares}\times \\ \text{Conversion rate}\end{array}\right\}\\ \text{=5,000 shares×15}\\ \text{= 75,000}\end{array}$                  

3.

To determine

Identify the amount that will be reported as basic and diluted earnings per share for the year 2019.

Explanation of Solution

The Company M must report an amount of $1.95 as basic earnings per share and $1.64 as diluted earnings per share in its 2019 income statement.