Diluted Earnings Per Share

Diluted Earnings Per Share

▪ The diluted earnings per share figure is computed and reported if the
firm has at least one dilutive security in its capital structure.
▪ Remember, there are three types of dilutive securities: convertible
bonds, convertible preferred stock, and warrants.
▪ If any one of these exists in the company’s capital structure, both basic
and diluted earnings per share must be reported. If there are no dilutive
securities, only basic earnings per share is reported.
▪ When the earnings per share figure is lower than the basic earnings per
share, it is referred to as diluted earnings per share. If the earnings per
share figure is higher than the basic, it is referred to as anti-diluted
earnings per share.
Convertible Bonds
Convertible Bonds
Diluted EPS is just an imaginary figure. We assume a hypothetical scenario in which the convertible
securities are converted on the first day of the year and show decision makers what the earnings per
share figure would look like if the securities are converted. However, it does not mean that the
securities were in fact converted.

Net Income Preferred dividends Interest saved

Diluted earnings per share (DEPS) net of tax
Weighted average number of
common shares outstanding Converted shares

Interest saved net of tax
If the bonds are converted, the company will not pay interest on the
bonds so it will save this interest and this will increase net income.
However, since income increases, the government will collect more taxes.
Thus, we calculate the amount of interest net of taxes that increased as
a result of not paying this interest expense.

Interest saved net of tax = Interest expense 1 – tax rate 4

Example
Polaris had 10,000,000 ordinary shares on January 1, 2014. The company issued 20,000
$100 units of 6% convertible bonds redeemable at par on 1 January 2016. Each $100 bond
is convertible into 400 ordinary shares at the option of the holder. On June 1, 2014, the
company made a 1 for 2 bonus issue. On 1 July 2014, the company issued 5,000,000 new
shares at the market price. The company’s year-end is 31 December. Its profit after tax
is $2,765,000. The tax rate is 30%.
1
Bonus issue 10,000,000 5,000,000 10,000,000 15,000,000
2

Weighted average # 6 6
15,000,000 20,000,000 17,500,000
of common shares 12 12

2,765,000
Basic EPS $0.158
17,500,000

5
 Continued
Polaris had 10,000,000 ordinary shares on January 1, 2014. The company issued 20,000
$100 units of 6% convertible bonds redeemable at par on 1 January 2016. Each $100 bond
is convertible into 400 ordinary shares at the option of the holder. On June 1, 2014, the
company made a 1 for 2 bonus issue. On 1 July 2014, the company issued 5,000,000 new
shares at the market price. The company’s year-end is 31 December. Its profit after tax
is $2,765,000. The tax rate is 30%.

Interest expense 20,000 $100 6% $120,000

Interest saved net of tax $120,000 1 – .30 $84,000

Converted shares 20,000 400 shares 8,000,000

2,765,000 2,765,000 84,000

Basic EPS $0.158 Diluted EPS $0.11
17,500,000 17,500,000 8,00,000

6
Convertible Preferred Stock
Convertible Preferred Stock
The assumption here is that the convertible preferred stock had been converted into shares of
common stock since the beginning of the period. If the preferred stock is converted into common stock
then preferred dividends would not be paid since there are no longer any preferred stock
hypothetically.

Preferred
Net Income Preferred dividends dividends
Diluted earnings per share (DEPS)
Weighted average number of
common shares outstanding Converted shares

There is no interest on preferred stock. Therefore, we do not add interest saved net of tax
since it does not exist!

8
Example
Complex Company has net income of $1,710,000, the tax rate is 30%, and the capital structure of the
company includes common stock, nonconvertible and convertible, cumulative, preferred stock. The following
information is available.
Common shares: 270,000 shares of common stock outstanding on January 1.
Sold 18,000 common shares on September 1.
Nonconvertible, cumulative, 6% preferred stock, par value of $20: 7,500 shares.
Cumulative, convertible 4% preferred stock, par value of $10: 5,000 shares.
The preferred stock is convertible at the rate of 5 common shares for one preferred stock.
Preferred stock dividends (nonconvertible) 7,500 $20 6% $9,000

Preferred stock dividends (convertible) 5,000 $10 4% $2,000

8 4
Weighted average # of 270,000 288,000 276,000
common shares 12 12

Converted shares 5,000 5 25,000

1,710,000 9,000 2,000

Basic EPS $6.16
276,000
9
Example
Complex Company has net income of $1,710,000, the tax rate is 30%, and the capital structure of the
company includes common stock, nonconvertible and convertible, cumulative, preferred stock. The following
information is available.
Common shares: 270,000 shares of common stock outstanding on January 1.
Sold 18,000 common shares on September 1.
Nonconvertible, cumulative, 6% preferred stock, par value of $20: 7,500 shares.
Cumulative, convertible 4% preferred stock, par value of $10: 5,000 shares.
The preferred stock is convertible at the rate of 5 common shares for one preferred stock.
Preferred stock dividends (nonconvertible) 7,500 $20 6% $9,000

Preferred stock dividends (convertible) 5,000 $10 4% $2,000

8 4
Weighted average # of 270,000 288,000 276,000
common shares 12 12

Converted shares 5,000 5 25,000

1,710,000 9,000 2,000 2,000

Diluted EPS $5.65
276,000 25,000
10
Warrants
Warrants
The assumption here is that investors exercised their right to purchase the stock at its predetermined
price and thus the number of shares increase. In the context of diluted earnings per share, stock
warrants have no effect on net income since there is no interest saved or preferred dividend impact.
However, we add the net new shares.

No effect on net
Net Income Preferred dividends
income
Diluted earnings per share (DEPS)
Weighted average number of
common shares outstanding Net new shares

Net new shares: This is an assumption that the firm uses the cash it receives from the sale of
stock to repurchase its own shares of common stock from the market, thereby decreasing the
number of outstanding shares.

12
Example
Complex Company has net income of $1,710,000, the tax rate is 30%, and the capital structure of the
company includes common stock, nonconvertible and convertible, cumulative, preferred stock. The following
information is available.
Common shares: 270,000 shares of common stock outstanding on January 1.
Sold 18,000 common shares on September 1.
Nonconvertible, cumulative, 6% preferred stock, par value of $20: 7,500 shares.
Stock options (warrants) convertible into 6,000 shares. The option price is $20. the average market price
for the year is $25.
Preferred stock dividends (nonconvertible) 7,500 $20 6% $9,000

8 4
Weighted average # of 270,000 288,000 276,000
common shares 12 12

Converted shares 6,000 $20 $120,000

$120,000 Net new shares 6,000 $4,800

Shares repurchased 4,800 shares
$25 1,200 shares

1,710,000 9,000
Basic EPS $6.16
276,000 13
Example
Complex Company has net income of $1,710,000, the tax rate is 30%, and the capital structure of the
company includes common stock, nonconvertible and convertible, cumulative, preferred stock. The following
information is available.
Common shares: 270,000 shares of common stock outstanding on January 1.
Sold 18,000 common shares on September 1.
Nonconvertible, cumulative, 6% preferred stock, par value of $20: 7,500 shares.
Stock options (warrants) convertible into 6,000 shares. The option price is $20. the average market price
for the year is $25.
Preferred stock dividends (nonconvertible) 7,500 $20 6% $9,000

8 4
Weighted average # of 270,000 288,000 276,000
common shares 12 12

Converted shares 6,000 $20 $120,000

$120,000 Net new shares 6,000 $4,800

Shares repurchased 4,800 shares
$25 1,200 shares

No effect on
1,710,000 9,000 net income
Diluted EPS $6.14
276,000 1,200 14
Example
Last year, Baura Baguette reported net income of $100,000 and had 50,000 shares of common stock and 200
convertible bonds outstanding for the year. Each convertible bond is a $1,000 par value, pays 3% interest,
and is convertible into 100 shares of common stock. The tax rate is 30%. Calculate basic and diluted earnings
per share.

Interest expense 200 $1,000 3% $6,000

Interest saved net of tax $6,000 1 .30 $4,200

Converted shares 200 100 20,000

100,000 5,000
Basic EPS $1.90
50,000

100,000 4,200
Diluted EPS $1.49
50,000 20,000
15
Consolidated Diluted
Earnings Per Share
 Parent’s adjusted internally Parent’s DEPS Parent owned Subsidiary DEPS
generated net income income adjustments equivalent shares

Weighted average parent company Parent’s DEPS share adjustments

common shares outstanding
Example
A subsidiary company’s net income adjusted for intercompany profits is $22,000. Preferred stock cash dividends
are $2,000. Interest paid on convertible bonds net of tax is $3,000. Common shares outstanding are 5,000. The
subsidiary also has 1,000 warrants to purchase one share of common stock for $5 per share. The average market
price is $10 per share. 50% 0f the warrants are held by the parent. There are also 200 convertible bonds
outstanding (convertible into 10 shares of common stock), and 90% 0f the convertible bonds are held by the
parent.
Net new shares
$5,000
1000 $5 $5,000 500 shares
$10
Net new shares = 1,000 500 500 shares

22,000 2,000 3,000

Subsidiary DEPS = $3.07
5,000 2,000 500 17
 Parent’s adjusted internally Parent’s DEPS Parent owned Subsidiary DEPS
generated net income income adjustments equivalent shares

Weighted average parent company Parent’s DEPS share adjustments

common shares outstanding
Example
Assume the parent owns 80% of the subsidiary and has an adjusted internally generated net income of $40,000 and
10,000 shares of common stock. Also, assume the parent has dilutive bonds outstanding that are convertible into
3,000 shares of common stock and the interest saved net of tax on these bonds was $5,000. 50% 0f the subsidiary
company’s warrants are held by the parent. There are also 200 convertible bonds outstanding in the subsidiary
company (convertible into 10 shares of common stock), and 90 % 0f these convertible bonds are held by the parent.

Subsidiary common
shares owned by parent 5000 80% 4,000

Parent owned equivalent

shares of convertible 2,000 90% 1,800
bonds
Parent owned equivalent
shares of warrants 500 50% 250
18
6,050
 Parent’s adjusted internally Parent’s DEPS Parent owned Subsidiary DEPS
generated net income income adjustments equivalent shares

Weighted average parent company Parent’s DEPS share adjustments

common shares outstanding
Example
Assume the parent owns 80% of the subsidiary and has an adjusted internally generated net income of $40,000 and
10,000 shares of common stock. Also, assume the parent has dilutive bonds outstanding that are convertible into
3,000 shares of common stock and the interest saved net of tax on these bonds was $5,000. 50% 0f the subsidiary
company’s warrants are held by the parent. There are also 200 convertible bonds outstanding in the subsidiary
company (convertible into 10 shares of common stock), and 90 % 0f these convertible bonds are held by the parent.

40,000 5,000 6,050 3.07

Consolidated DEPS = $4.89

10,000 3,000

19
End of Lecture!
Any questions?
You can find me at:
▪ Tarek.Elkalla@gmail.com

20