Question

Kodiak Construction Company has experienced generally steady growth since its inception in 1953. Management is proud of its record of having maintained or increased its earnings per share in each year of its existence.

The economic downturn has led to disturbing dips in revenues the past two years. Despite concerted cost-cutting efforts, profits have declined in each of the two previous years. Net income in 2016, 2017, and 2018 was as follows:

2016	$145 million
2017	$134 million
2018	$95 million

A major shareholder has hired you to provide advice on whether to continue her present investment position or to curtail that position. Of particular concern is the declining profitability, despite the fact that earnings per share has continued a pattern of growth:

		Basic		Diluted
2016		$2.15		$1.91
2017		$2.44		$2.12
2018		$2.50		$2.50

She specifically asks you to explain this apparent paradox. During the course of your investigation you discover the following events:

• For the decade ending December 31, 2015, Kodiak had 60 million common shares and 20 million shares of 8%, $10 par nonconvertible preferred stock outstanding. Cash dividends have been paid quarterly on both.
• On July 1, 2017, half the preferred shares were retired in the open market. The remaining shares were retired on December 30, 2017.
• $55 million of 8% nonconvertible bonds were issued at the beginning of 2018, and a portion of the proceeds were used to call and retire $50 million of 10% debentures (outstanding since 2013) that were convertible into 9 million common shares.
• In 2016, management announced a share repurchase plan by which up to 24 million common shares would be retired. 12 million shares were retired on March 1 of both 2017 and 2018.
• Kodiak’s income tax rate is 40% and has been for the last several years.

Required:

Explain the apparent paradox to which your client refers. Include calculations that demonstrate your explanation.

Answer 1