Question

Strickland Corporation earned net income of $300,000 (after taxes at a rate of 40%) in 2017. It had 100,000 shares of common stock outstanding all year, and 50,000 shares of preferred stock, non-convertible, non-cumulative. Dividends of $20,000 were declared and paid on the preferred.

The company also had $400,000 of 10% convertible bonds (sold at par value) convertible into 16,000 shares of common stock.

The company had outstanding stock options for 5,000 shares of common stock at an exercise price of $20. The average market price during the year was $40.

Compute basic earnings per share.

Identify whether the BONDS are dilutive or anti-dilutive, showing computations to support your answer.

Compute diluted earnings per share.

Answer 1

Earnings Per share =

(Net Income attributable to common stock holders’/weighted average number of shares outstanding)

Net income after tax	300,000
Less: Preferred dividends	20,000
Net Income attributable to common stockholders’	280,000
No of shares outstanding	100,000

Earnings per share = $280,000/100,000 = $2.80 per share

Convertible Bonds

If bonds convert into shares, then company will save interest of 400,000*10% =$40,000 pre tax

After tax interest = 24,000 {40000*(1-.4)}

Total Income after interest saving = 280,000+24,000 = $304,000

Number of shares outstanding increased by 16,000 shares = 100,000+16,000 =116,000 shares

Earnings per share = 304,000/116,000 = $ 2.62 per share

Bonds are dilutive because Earnings per share before conversion $2.80 is reduced to $2.62 per share after conversion

Stock Options

Number of shares increased/(Decreased) if option was exercised =

{[(Market price -Exercise price)/Market price] *Number of options

= {[(40-20)/40] *5,000} = 2,500 shares

Income Increased = $0

So Net Income after Conversion of Bonds and options exercised = $280,000+24,000+0 = $304,000

Number of shares after conversion of bonds and options exercised= 100,000 +16,000 + 2,500 = 118,500 shares

Dilutive earning per share = 304,000/118,500 = $2.57 per share