Question

On December 31, 2017, Dow Steel Corporation had 620,000 shares of common stock and 32,000 shares of 10%, noncumulative, nonconvertible preferred stock issued and outstanding. Dow issued a 5% common stock dividend on May 15 and paid cash dividends of $420,000 and $71,000 to common and preferred shareholders, respectively, on December 15, 2018.

On February 28, 2018, Dow sold 64,000 common shares. Also, as a part of a 2017 agreement for the acquisition of Merrill Cable Company, another 20,000 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 $520,000. In 2018, Merrill's net income was $650,000.

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 $2,200,000. 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		9,000		$	16
December 31, 2017		4,000		$	25
December 31, 2018		7,500		$	24

The market price of the common stock averaged $24 per share during 2018.

On July 12, 2016, Dow issued $600,000 of convertible 10% bonds at face value. Each $1,000 bond is convertible into 35 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

For the calculation of basic EPS:

Net income = $2200000

Preference dividends = $71000

Stock dividend = 5%

Weighted average number of shares =

1/1 - 31/12 = 620000 * 12/12 *1.05 = 651000.......(1)

28/2 - 31/12 = 64000 * 10/12 * 1.05 = 56000.........(2)

1/7 - 31/12 = (4000 * 6/12) = (2000).....................(3)

Adding 1, 2 , 3

Weighted average number of shares = 651000 + 56000 - 2000

Weighted average number of shares = 705000 shares

Basic EPS = net income - preference dividends / Weighted average number of shares

Basic EPS = (2200000 - 71000) / 705000

Basic EPS = $3.0198

or Basic EPS = $0.00302

For dilutive EPS:

1. 9000 options are dilutive because market price of share is more than exercise price.

Net proceeds = 9000 * 16 = $14400

Shares repurchased at current price = 14400 / 24 = 6000 shares

Net increase/decrease in shares = 9000 - 6000 = 3000 shares

2. 4000 options are not dilutive because market price of share is less than exercise price.

3. 7500 options are not dilutive because market price of share is not more than exercise price.

Thus, only 9000 options are considered for calculation of dilutive EPS.

Dilutive EPS = (net income - preference dividends) /(Weighted average number of shares + increase in shares)

Dilutive EPS = (2200000 -71000) / (705000 + 3000)

Dilutive EPS = 2129000 / 708000

Dilutive EPS = $3.00706

Or Dilutive EPS = $0.003