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Chapter19: Share-Based Compensation and Earnings Per Share

Antidilutive Securities

At times, the effect of the conversion or exercise of potential common shares would be to increase, rather than decrease, EPS. These we refer to as antidilutive securities the effect of the conversion or exercise of potential common shares would be to increase rather than decrease, EPS.. Such securities are ignored when calculating both basic and diluted EPS.

Options, Warrants, Rights

For illustration, recall the way we treated the stock options in our continuing illustration. In applying the treasury stock method, the number of shares assumed repurchased is fewer than the number of shares assumed sold. This is the case any time the buyback (average market) price is higher than the exercise price. Consequently, there will be a net increase in the number of shares, so earnings per share will decline.

 LO10

   On the other hand, when the exercise price is higher than the market price, to assume shares are sold at the exercise price and repurchased at the market price would mean buying back more shares than were sold. This would produce a net decrease in the number of shares. EPS would increase, not decrease. These would have an antidilutive effect and would not be considered exercised. In fact, a rational investor would not exercise options at an exercise price higher than the current market price anyway. Let's look at the example provided by Illustration 19-12.

Antidilutive securities are ignored when calculating both basic and diluted EPS.

ILLUSTRATION 19-12

Antidilutive Warrants

The $32.50 exercise price is higher than the market price, $25, so to assume shares are sold at the exercise price and repurchased at the market price would mean reacquiring more shares than were sold.

  Sovran Financial Corporation reported net income of $154 million in 2011 (tax rate 40%). Its capital structure included:

Common Stock

Jan. 1

60 million common shares were outstanding

Mar. 1

12 million new shares were sold

June 17

A 10% stock dividend was distributed

Oct. 1

8 million shares were reacquired as treasury stock

(The average market price of the common shares during 2011 was $25 per share.)

Preferred Stock, Convertible into 3 million common shares.
January 1–December 31   5 million 8%, $10 par, shares

Incentive Stock Options
Executive stock options granted in 2006, exercisable after 2010 for 15 million common shares* at an exercise price of $20 per share

Convertible Bonds
10%, $300 million face amount issued in 2010, convertible into 12 million common shares

Stock warrants
Warrants granted in 2010, exercisable for 4 million common shares* at an exercise price of $32.50 per share

Calculations:
The calculations of both basic and diluted EPS are unaffected by the warrants because the effect of exercising the warrants would be antidilutive.

*Adjusted for the stock dividend. For example, prior to the stock dividend, the warrants were exercisable for <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_im1915.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a> of the “old” shares which became <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_im1916.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a> of the “new” shares after the stock dividend.

   To assume 4 million shares were sold at the $32.50 exercise price and repurchased at the lower market price ($25) would mean reacquiring 5.2 million shares. That's more shares than were assumed sold. Because the effect would be antidilutive, we would simply ignore the warrants in the calculations.

p. 1093

   In our continuing illustration, only the stock warrants were antidilutive. The other potential common shares caused EPS to decline when we considered them exercised or converted. In the case of the executive stock options, it was readily apparent that their effect would be dilutive because the exercise price was less than the market price, indicating that fewer shares could be repurchased (at the average market price) than were assumed issued (at the exercise price). As a result, the denominator increased. When only the denominator of a fraction increases, the fraction itself decreases. On the other hand, in the case of the warrants, it was apparent that their effect would be antidilutive because the exercise price was higher than the market price, which would have decreased the denominator and therefore increased the fraction.

   When a company has a net loss, rather than net income, it reports a loss per share. In that situation, stock options that otherwise are dilutive will be antidilutive. Here's why. Suppose we have a loss per share of $2.00 calculated as ($150 million) ÷ 75 million shares = ($2.00). Now suppose stock options are outstanding that, if exercised, will increase the number of shares by 5 million. If that increase is included in the calculation, the loss per share will be $1.88 calculated as ($150 million) ÷ 80 million shares = ($1.88). The loss per share declines. This represents an increase in performance—not a dilution of performance. The options would be considered antidilutive, then, and not included in the calculation of the net loss per share. Any potential common shares not included in dilutive EPS because they are antidilutive should be revealed in the disclosure notes.

Convertible Securities

For convertible securities, though, it's not immediately obvious whether the effect of their conversion would be dilutive or antidilutive because the assumed conversion would affect both the numerator and the denominator of the EPS fraction. We discovered each was dilutive only after including the effect in the calculation and observing the result—a decline in EPS. But there's an easier way.

   To determine whether convertible securities are dilutive and should be included in a diluted EPS calculation, we can compare the “incremental effect” of the conversion (expressed as a fraction) with the EPS fraction before the effect of any convertible security is considered. This, of course is our basic EPS. Recall from Illustration 19-11 that basic EPS is $2.00.

   For comparison, we determine the “earnings per incremental share” of the two convertible securities:

Conversion of bonds.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_eq1911.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

The incremental effect (of conversion) of the bonds is the after-tax interest saved divided by the additional common shares from conversion.

Conversion of preferred stock.

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   If the incremental effect of a security is higher than basic EPS, it is antidilutive. That's not the case in our illustration.

The incremental effect (of conversion) of the preferred stock is the dividends that wouldn’t be paid divided by the additional common shares from conversion.

Order of Entry for Multiple Convertible Securities

A convertible security might seem to be dilutive when looked at individually but, in fact, may be antidilutive when included in combination with other convertible securities. This is because the order of entry for including their effects in the EPS calculation determines by how much, or even whether, EPS decreases as a result of their assumed conversion. Because our goal is to reveal the maximum potential dilution that might result, theoretically we should calculate diluted EPS using every possible combination of potential common shares to find the combination that yields the lowest EPS. But that's not necessary.

p. 1094

   We can use the earnings per incremental share we calculated to determine the sequence of including securities' effects in the calculation. We include the securities in reverse order, beginning with the lowest incremental effect (that is, most dilutive), followed by the next lowest, and so on. This is, in fact, the order in which we included the securities in our continuing illustration.

  
ADDITIONAL CONSIDERATION

Actually, the order of inclusion made no difference in our example, but would in many instances. For example, suppose the preferred stock had been convertible into 2.1 million shares, rather than 3 million shares. The incremental effect of its conversion would have been:

Conversion of Preferred Stock

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   On the surface, the effect would seem to be dilutive because $1.90 is less than $2.00, basic EPS. In fact, if this were the only convertible security, it would be dilutive. But, after the convertible bonds are assumed converted first, then the assumed conversion of the preferred stock would be antidilutive:

With Conversion of Bonds

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With Conversion of Preferred Stock

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_un1911.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

Although the incremental effect of the convertible preferred stock ($1.90) is lower than basic EPS ($2.00), when included in the calculation after the convertible bonds the effect is antidilutive (EPS increases).

  






Because the incremental effect of the convertible bonds ($1.50) is lower than the incremental effect of the convertible preferred stock ($1.90), it is included first.







A convertible security might seem to be dilutive when looked at individually but may be antidilutive when included in combination with other convertible securities.



p. 1095

CONCEPT REVIEW EXERCISE

BASIC AND DILUTED EPS

At December 31, 2011, the financial statements of Clevenger Casting Corporation included the following:

Net income for 2011

$500 million

Common stock, $1 par:

  Shares outstanding on January 1

  150 million shares

  Shares retired for cash on February 1

  24 million shares

  Shares sold for cash on September 1

  18 million shares

  2-for-1 split on July 23

Preferred stock, 10%, $60 par, cumulative, nonconvertible

$ 70 million

Preferred stock, 8%, $50 par, cumulative, convertible into 4 million shares of common stock

$100 million

Incentive stock options outstanding, fully vested, for 4 million shares of common stock; the exercise price is $15

Bonds payable, 12.5%, convertible into 20 million shares of common stock

$200 million

   Additional data:

   The market price of the common stock averaged $20 during 2011.

   The convertible preferred stock and the bonds payable had been issued at par in 2009. The tax rate for the year was 40%.

Required:

Compute basic and diluted earnings per share for the year ended December 31, 2011.

(amounts in millions, except per share amounts)

SOLUTION

Basic EPS

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Diluted EPS

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_un1913.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

p. 1096

Dilution:

Conversion of Bonds

Conversion of 8% Preferred Stock

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_eq1915.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_eq1916.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>




a10% × $70 million = $7 million

b8% × $100 million = $8 million

cExercise of warrants:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_eq1914.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

d 12.5% × $200 million = $25 million

*Because the incremental effect of conversion of the preferred stock ($2) is higher than EPS without the conversion of the preferred stock, the conversion would be antidilutive and is not considered in the calculation of diluted EPS.

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