Question

Cottonwood Company has net income of $600,000. It had 500,000 shares of common stock throughout 2015. It also had 50,000 shares of convertible preferred stock. Each share pays an annual dividend of $3 and each preferred share can be converted into 4 shares of common stock. Cottonwood also had 20,000 stock options outstanding. Each option can be used to purchase a share of common stock at $22 per share. The average market price of common stock for 2015 was $20. The company also has $200,000 of 8% convertible bonds. Each $1,000 bond can be converted into 20 shares of common stock. No conversion took place during 2015; however, the preferred stock, options, and bonds all could have been converted any time during the year. Cottonwood's tax rate is 45%. $200,000 of cash dividends were declared and paid during the year.

Which of the following would be considered antidilutive [mark all that apply]?

Answer 1

Basic EPS of the company = earning attributable to shareholders / weighted average number of shares

= 600000-(50000x3)/500000

= 0.9

First of all we should calculate what if potential equity shares were actually equity shares which is called incremental ratio, then incorporate those changes in basic EPS in ascending order of incremental ratio, which is called adjusting rstio, if adjusting ratios increases at any step then such potential equity shares and the remaining thereafter are called antidilutive. It can be simply understood in following way :-

Incremental ratio (what is effect on numerator and denominator of basic eps of if they were equity shares

1 Convertible preference shares = 50000x3/50000x4

= 0.75

2. Convertible bonds = 200000x8%x(1-0.45)/4000^{* = 8800/4000 = 2.2}

* Number of convertible shares = (20/1000)x200000 = 4000 shares

3 . Options = 0/20000 = 0

Thus order preference in incorporating the effect to basic eps will be (ascending order on the basis of incremental ratio) :-

1. Options

2 .convertible preference shares.

3. Convertible bonds

Testing for antidilutive (if eps increases then antidilutive) :-

	Numerator	denominator	ratio
Basic EPS	450000	500000	0.9
Options	0	20000
Total after options	450000	520000	0.87
Convertible preference shares	150000	200000
Total after preference shares	600000	720000	0.83
Convertible bonds	8800	4000
Total after bonds	608800	724000	0.84

Since eps ratio increases after incorporating the effect of convertible bonds. Thus, convertible bonds are anti dilutive.