Question

Q: Which security, if converted, would have the greatest impact on Company B's Basic EPS?

My answer was: the decrease in EPS will be greater with conversion of the debentures since the two securities convert into an equal number of common shares.

Q: So, if the convertible 8% preferred stock and convertible 8% debentures are convertible for 10 shares of common stock, how do I calculate that the conversion of debentures would have the greater effect on EPS?

Your answer/explanation:

Answer 1

The Conversion of Debentures would result in greater decrease in the basic EPS as the interest paid on debentures is generally tax deductable under many tax jurisdictions while the prefrence dividend is not a tax deductible expense.

Hence in case of conversion of debentures the company would loose the tax advantage which would lead to lesser amount of gain in profit attributable to equity shares in comparisson to preference shares due to conversion.

For Eg. if a company has

Net Profit = 100,000

Outstanding Shares = 10,000

Basic EPS = 10

8% Convertible Preference shares (10/- Each) = 10,000  

8% Convertible Debentures (10/- Each) = 10,000

Both are convertible to 1,000 common shares

Tax Rate = 20%

In Case of conversion of Preference shares:

Increse in profit attributable to equity shares = Preference dividend = 8% of 10,000 = 800

and Basic EPS = (100,000 + 800) / (10,000 + 1,000) = 9.164

In Case of conversion of Debentures:

Increse in profit attributable to equity shares = Interest on debentures x (1 - Tax Rate)

= 8% x (1-0.2) x 10,000 = 640

and Basic EPS = (100,000 + 640) / (10,000 + 1,000) = 9.149