Question

1)Gamma reported $600,000 net income for the year with 100,000 common shares outstanding all year. It also had 50,000 shares of $100 par, 8% convertible preferred shares outstanding all year. Each preferred share is convertible into 10 shares of common stock. Determine basic and diluted EPS.

2)Alpha reported net income of $500,000 for the year. It has 200,000 shares of common stock outstanding all year. Two years ago the company granted 20,000 stock options that allow employees to purchase shares for $15 each. The company stock has averaged $20 in the market during the year. Compute the basic and diluted EPS.

Answer 1

Answer to Question No 1:

Basic EPS:

Computation of Earnings available to Common share holders (EACSH) or Basic Earnings:

Particulars	Computation	Amount($)
Net Income		600000
Preferesnce Dividend	50000 shares*100$*8%	400000
EACSH or Basic Earnings		200000

Basic EPS = Earnings available to Common share holders (EACSH)/ Weighted Average Number of Common shares(WANCS)

Basic EPS= EACSH/WANCS

= 200000/100000 = 2$ per share

Diluted EPS:

Diluted EPS = (Basic Earnings + Savings in Dividend, interest etc araising due to conversion) / (WANCS+ Prospective shares)

Basic Earnings = 200000

Savings in Dividend = if Preference shares are converted already , the prefereance dividend can be saved. So, Savings will be amount of preference dividend = 400000

Prospective shares = Each preferred share is convertible into 10 shares of common stock = 50000 shares * 10 = 500000

Substituting all these values in the above formula,

Diluted EPS = (Basic Earnings + Savings in Dividend) / (WANCS+ Prospective shares)

= (200000+400000) / (100000+500000) = 1$ per share

Therefore,

Basic EPS = 2$ and Diluted EPS = 1$

Answer to Queation No 2:

Basic EPS= EACSH/WANCS

Earnings available to Common share holders (EACSH) = 500000

Weighted Average Number of Common shares(WANCS) = 200000

Basic EPS = 500000/200000= 2.5 $ per share

Diluted EPS:

Diluted EPS = (Basic Earnings + Savings in Dividend, interest etc araising due to conversion) / (WANCS+ Prospective shares)

Basic Earnings= 500000

Savingns = Nil

Weighted Average Number of Common shares(WANCS) = 200000

Prospective shares= 5000

Computation of Prospective shares:

Fair value or market value of shares in the Option = $20

Exercise price of share in the Option = $15

The difference between the fair value and the exercise price shall be considered as the Bonus. It will be considered while computing the Diluted EPS but not in computing the Basic EPS because, it is not the actual bonus issued on shares, it is notional bonus.

Hence, Bonus in Option = No. of options outstanding *(Concession per share/ Market price per share) and

Concession = Fair value or market value - Exercise price

Bonus shares = 20000*{(20-15)/20}

= 20000*(5/20) = 5000 shares

Then, Substituting all these valus in the follwing equation,

Diluted EPS = (Basic Earnings + Savings in Dividend, interest etc araising due to conversion) / (WANCS+ Prospective shares)

Diluted EPS = (500000+0)/(200000+5000) = 2.439$ per share

Therefore,

Basic EPS = 2.5$ and Diluted EPS = 2.439$ per share