Question

The following information is for Polo Limited for 2017:
Net income for the year ……………………………………………… $2,300,000
8% convertible bonds issued at par ($1,000 per bond), with each bond convertible into 30 common shares ………………………………………………………. 2,000,000
6% convertible, cumulative preferred shares, $100 par value, with each share convertible into 3 common shares ………………………………………………… 4,000,000
Common shares (600,000 shares outstanding) ………………………............................................................................................................................................6,000,000
Stock options (granted in a prior year) to purchase 75,000 common shares at $20 per share ………………………………………………………………………… 750,000
Tax rate for 2017 …………………………………………………………. 30%
Average market price of common shares ……………………….. $25 per share

There were no changes during 2017 in the number of common shares, preferred shares, or convertible bonds outstanding. For simplicity, ignore the requirement to book the convertible bonds’ equity portion separately.

Instructions
(a) Calculate basic earnings per share for 2017.
(b) Calculate diluted earnings per share for 2017.
(c) Discuss how a potential shareholder’s investment decision may be affected if diluted earnings per share was not reported

Answer 1

Q. (a) Calculate basic earnings per share for 2017.

Basic Earning Per Share will be= Net Income $2,300,000/ Common shares 600,000 shares outstanding)

$ 3.83 Per Share

(b) Calculate diluted earnings per share for 2017.

After Dilution to the Convertible Bonds (2000 Bonds*conversion into 30 Common shares=60000 Common Shares) + Dilution to Preferred Shares (40000*Conversion into 3 Coomon shares=120000 Common Shares) Total Common Shares by adding existing common shares 600000 + 60000+120000=780000

Earning Per Share (After Dilution will be) = Net Income $2,300,000/ Common shares 7,80,000 shares outstanding on diluted basis (ignoring Stock Options not exercised so far.)

If stock options are exercised than Number of Common Share will be further increased by 75000,

Earning Per Share will be =Net Income $2,300,000/ Common shares 855000

$ 2.69 Per Share

(c) Discuss how a potential shareholder’s investment decision may be affected if diluted earnings per share was not reported.

Offcourse, if diluted earnings per share are not disclosed than the Investors will be kept in dark, as the EPS, PE Ratio both will be reported wrongly to the Investors and a rosy picture will be shown to the Investors with higher EPS and low PE Ratio which will be not true one.