Question

–M Inc. issued 2,000 convertible bonds in 2009 at a coupon rate of 8% and a par value of £1,000. Each bond is convertible into M Inc.’s common stock at £25 per share.

M Inc. expected the stock price to rise rapidly after the convertible was issued and lead to a quick conversion of the bond debt into equity. However, a recessionary climate has prevented that from happening, and the bonds are still outstanding. In 2010 M Inc. had net income of £3 million. One million share of its stock were outstanding for the entire year, and its marginal tax rate is 40%.

Calculate M Inc.’s basic and diluted EPS. (Diluted EPS assumes all convertible bonds are converted at the beginning of the year)

Answer 1

i) Earnings per share (EPS) = Net income / Outstanding shares

EPS = £3 million / 1 million shares

EPS = £3 per share

ii) Diluted EPS = Net income available to equity shareholders / (Outstanding shares + Convertible shares)

Here, Outstanding shares = 10,00,000 shares

a) Net income available to equity shareholders = Net income + Convertible debt interest * (1 - Tax rate)

Tax rate = 40% or 0.40

Convertible debt interest = Convertible debt * Coupon rate

Convertible debt interest = (£1,000 Par value * 2,000 convertible bonds) * 8%

Convertible debt interest = £1,60,000

Net income available to equity shareholders = £30,00,000 + £1,60,000 * (1 - 0.40)

Net income available to equity shareholder's = £30,96,000

b) Convertible shares = Convertible bonds * (Bonds par value / Stock price per share)

Convertible shares = 2,000 * (£1,000 / £25)

Convertible shares = 2,000 * 40

Convertible shares = 80,000 shares

Now,

Diluted EPS = £30,96,000 / (10,00,000 + 80,000) shares

Diluted EPS = £30,96,000 / 10,80,000 shares

Diluted EPS = £2.867 per share