Question

On December 31, 2017, Dow Steel Corporation had 670,000 shares of common stock and 37,000 shares of 7%, noncumulative, nonconvertible preferred stock issued and outstanding. Dow issued a 4% common stock dividend on May 15 and paid cash dividends of $470,000 and $76,000 to common and preferred shareholders, respectively, on December 15, 2018.

On February 28, 2018, Dow sold 51,000 common shares. Also, as a part of a 2017 agreement for the acquisition of Merrill Cable Company, another 30,000 shares (already adjusted for the stock dividend) are to be issued to former Merrill shareholders on December 31, 2019, if Merrill's 2019 net income is at least $570,000. In 2018, Merrill's net income was $700,000.

In keeping with its long-term share repurchase plan, 4,000 shares were retired on July 1. Dow's net income for the year ended December 31, 2018, was $2,450,000. The income tax rate is 40%.

As part of an incentive compensation plan, Dow granted incentive stock options to division managers at December 31 of the current and each of the previous two years. Each option permits its holder to buy one share of common stock at an exercise price equal to market value at the date of grant and can be exercised one year from that date. Information concerning the number of options granted and common share prices follows:

Date Granted	Options Granted			Share Price
	(adjusted for the stock dividend)
December 31, 2016		14,000		$	20
December 31, 2017		9,000		$	29
December 31, 2018		12,500		$	28

The market price of the common stock averaged $28 per share during 2018.

On July 12, 2016, Dow issued $500,000 of convertible 10% bonds at face value. Each $1,000 bond is convertible into 62 common shares (adjusted for the stock dividend).

Required:
Compute Dow's basic and diluted earnings per share for the year ended December 31, 2018. (Enter your answers in thousands.)

Answer 1

Basic EPS = $3.212   

Diluted EPS = $3.17

CALCULATIONS

1. Basic EPS

Numerator (Basic EPS)

a. Net income = $2,450,000;                                          

b. Preferred dividends = $76,000 (because the preferred stock is noncumulative, only include the dividends that are actually paid).                                   

                                                                                               

Denominator (Basic EPS)

: Weighted average number of shares of common stock outstanding

Date
1/1 - 12 / 31	670,000 x (12/12) =670000 * 1.04	= 696800
2 / 28 - 12 / 31	51,000 x (10/12) = 42500 x 1.04	=44200
7 / 1 - 12 / 31	(4000) x (6 /12)	=-2000
	Weighted average number of shares	739000

Basic EPS

= (Net income - Preferred dividends) / Weighted average number of shares of common stock outstanding

= ($2,450,000 - $76,000) *·739000

Basic EPS = $3.212    

2. Diluted EPS

a. Stock Options: Use the Treasury Stock Method if dilutive.                           

14000 options issued 12/31/16 with exercise price of $20.                                                                                                                           

• Are they dilutive? Yes, because the exercise price of $20 < market       

price of $28. Assume exercise at the later of the date of issue (12/31/16) or the beginning of the year (1/1/18).               Proceeds received upon exercise ($20 x14,000) = $280000

b. Shares repurchased at current market price = 10000 ($280000 / $28)     

c. Net increase in number of shares = 4,000 (14,000 - 10,000)       

d. 9000 options issued 12/31/17 with exercise price of $29.                          

• 1. Are they dilutive? No because the exercise price $29 is not less than   

the market price of $28. Therefore, ignore.                                                             

e.12,500 options issued 12/31/18 with exercise price of $28.                           

• 1. Are they dilutive? No because the exercise price of $28 is not less        

than the market price of $28. Therefore, ignore.           

    

Diluted EPS = (Net income - Preferred dividends) / ( Weighted average number of shares of common stock outstanding+Shares repurchased )

= ($2,450,000 - $76,000) / (739000 + 10,000) = $3.17   

   Diluted EPS = $3.17

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