The Effect of Security Type on Earnings Per Share Stage Corporation Has Both Convertible
The Effect of Security Type on Earnings per Share Stage Corporation has both convertible preferred stock and convertible debentures outstanding at the end of 20X3. The annual cash payment to the preferred shareholders and to the bondholders is the same, and the two issues convert into the same number of common shares. Required : • If both issues are dilutive and are converted into common stock, which issue will cause the larger reduction in basic earnings per share when converted? Why? • If both issues are converted into common stock, which issue will cause the larger increase in consolidated net income when converted? • If the preferred shares remain outstanding, what conditions must exist for them to be excluded entirely from the computation of basic earnings per share?
• Stage is a subsidiary of Prop Company. How will these securities affect the earnings per share reported for the consolidated enterprise?
Answer 1
If both the bonds and preferred stock are issued and converted into common stock then bonds will dilute the EPS more . it could be made clear by the following example
EXAMPLEEBIT / 100000
less interest expense / -10000
EBT / 90000
TAX @ 20 % / -18000
EAT / 72000
preferred dividend / -10000
Profit available to common stock holder / 62000
Basic EPS @ 20000 shares / 3.1
IF Bonds are converted
EBIT / 100000
EBT / 100000
TAX @ 20 % / -20000
EAT / 80000
preferred dividend / -10000
Profit available to common stock holder / 70000
Diluted EPS @ 20000+4000 shares / 2.92
EBIT / 100000
less interest expense / -10000
EBT / 90000
TAX @ 20 % / -18000
EAT / 72000
Profit available to common stock holder / 72000
Diluted EPS @ 20000+4000 shares / 3.0
It is clear that if the bonds are converted into common stock then bond conversion is diluting the EPS while the conversion of preferred stock is also diluting EPS but less than bonds the reason behind this is that bonds have a tax shield for interest expense while the preference dividend is not a tax deductible expense.
? • If the preferred shares remain outstanding, what conditions must exist for them to be excluded entirely from the computation of basic earnings per share?
Answer 2
IF company is suffering from losses then it would not have to pay any kind of dividend even the preference dividend so in this case the preference dividend would be excluded from earning per share.
• Stage is a subsidiary of Prop Company. How will these securities affect the earnings per share reported for the consolidated enterprise?
Answer 3
IF the conversion takes place then the number of shares of the subsidiary will increase it would not increase the parent’s shareholding but increase in number of shares would reduce the percentage of holding by parent and hence its share in profits would also be reduced due to reduction in shareholding percentage.
But EPS will be directly proportional to the EPS of the stage company as a whole because if the EPS of stage will decrease it would decrease the consolidated EPS.