Question

Peters Corp.’s capital structure was as follows:

	December 31
	Year 7	Year 8
Outstanding shares of stock:
Common	100,000	100,000
Convertible preferred	10,000	10,000
9% convertible bonds	$1,000,000	$1,000,000

During Year 8, Peters paid dividends of $3.00 per share on its preferred stock. The preferred shares are convertible into 20,000 shares of common stock, and the 9% bonds are convertible into 30,000 shares of common stock. Assume that the income tax rate is 30%.

If net income for Year 8 is $170,000, Peters should report DEPS as

A. $1.40

B. $1.56

C. $1.42

D. $1.70

Answer 1

Answer is A. $1.56

Explanation: All those securities that are likely to be converted into common share are included in calculation of DEPS in their order of most dilutive to the least dilutive securities. The degree of dilution is determined by the increasing effect on earning per share (E.P.S). Securities with lower incremental effect on E.P.S are more dilutive and vice versa. There are two convertible securities, Preferred shares and 9% convertible bonds. Therefore, we need to check the degree of dilution or the incremental effect on E.P.S.

Incremental effect on E.P.S of Preferred share:

Preferred Dividend = $3 10,000 shares = $30,000

Number of Convertible common stock = 20,000

The incremental effect on E.P.S/(DOD) = $30,000 20,000 = $1.5

Incremental effect on E.P.S of Bonds:

Interest on Bonds = $1,000,000 0.09 = $ 90,000

After tax, Interest on bonds = $90,000 (1 - 0.30) = $63,000

Number of Convertible common stock = 30,000

The incremental effect on E.P.S/(DOD) = $63,000 30,000 = $2.1

The preferred stock (1.5) is more dilutive than the Bonds ($2.1) but when it is compared with BEPS that is [ $170,000 - $30,000] 100,0000= $1.4, is lesser dilutive.

Because, both preferred stock ($1.5) and Bonds ($2.1) are higher than BEPS $1.40, and they are no more dilutive than BEPS, hence not included in calculation trial of DEPS.

So, Peters should report DEPS $1.4 in its Report for 2018.