Question

In applying the treasury stock method to determine the dilutive effect of stock options and warrants, the proceeds assumed to be received upon exercise of the options and warrants

are used to calculate the number of common shares repurchased at the average market price, when computing diluted earnings per share.

are disregarded in the computation of earnings per share if the exercise price of the options and warrants is less than the ending market price of common stock.

are added, net of tax, to the numerator of the calculation for diluted earnings per share.

are not used to calculate the number of common shared repurchased at the average market price, when computing diluted earnings per share.

Answer 1

The treasury stock method is an approach companies use to compute the number of new shares that may potentially be created by unexercised in-the-money warrants and options, where the exercise price is less than the current share price. Additional shares obtained through the treasury stock method factor into the calculation of the diluted earnings per share (EPS). This method assumes that the proceeds a company receives from an in-the-money option exercise are used towards repurchasing common shares in the market.

Consider a company that reports 100,000 basic shares outstanding, $500,000 in net income for the past year, and 10,000 in-the-money options and warrants, with an average exercise price of $50. Let's assume that the average market price for the shares in the last year was $100. Using the basic share count of the 100,000 common shares, the company's basic EPS is $5 calculated as the net income of $500,000 divided by 100,000 shares. But this number ignores the fact that 10,000 shares can be immediately issued if the in-the-money options and warrants are exercised.

Applying the treasury stock method, the company would receive $500,000 in exercise proceeds (calculated as 10,000 options and warrants times the average exercise price of $50), which it may use to repurchase 5,000 common shares on the open market at the average stock price of $100.

The additional 5,000 shares (the difference between 10,000 assumed issued shares, and 5,000 assumed repurchased shares) represent the net newly-issued shares resulting from the potential options and warrants exercise.

The diluted share count is 105,000 = 100,000 basic shares + 5,000 additional shares. The diluted EPS is then equal to $4.76 = $500,000 net income ÷ 105,000 diluted shares.