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This 0 page Class Notes was uploaded by Leonardo Klein on Sunday November 1, 2015. The Class Notes belongs to FOR 2003 at Oklahoma State University taught by Staff in Fall. Since its upload, it has received 18 views. For similar materials see /class/232806/for-2003-oklahoma-state-university in Environmental at Oklahoma State University.
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Date Created: 11/01/15
EARNINGS PER SHARE A CONCEPTUAL APPROACH BASED ON RATE OF RETURN oStatement No 128 requires companies with potential common stock outstanding to report two EPS numbers BEPS and DEPS Potential common stock also called potentially dilutive securities includes convertible debt convertible preferred stock and options to purchase a company s shares oBEPS equals net income available to common shareholders divided by the weighted average shares outstanding during the period This number is based on actual events oDEPS extends BEPS to include the effects of potentially dilutive securities potential common ie how these securities if converted or exercised could reduce EPS Thus DEPS includes the effects of hypothetical transactions and events oStatement No 128 is much simpler than ABPO No 15 and is closer to international standards for EPS Company facts Assets detailed 100000 Equity 100000 10000 shares 10 per share Company earns a 10 rate of return on assets and pays a cash dividend each year equal to that year s net income A and E 10000 income A and E 10000 dividend EPS BEPS 10000 NI 10000 shares 100 EPS signals profitability and profitability is in the numerator of EPS However EPS can also be affected by financing decisions some financing reflected in both numerator and denominator of EPS we must also consider events that may affect the denominator but that do NOT affect profitability FOR BASIC EARNINGS PER SHARE BEPS EPS SIGNALS FUTURE PROFITABILITY AND FUTURE CASH FLOWS 1 Rate of return approach illustrates how EPS numbers provide signals about present and future profitability and cash flows EXAMPLE 1 EXAMPLE 1 Visual Corp was organized on January 1 1983 and issued 10000 commn shares for 100000 The corr39pany has no debt outstanding and has always earned a 10 percent rate of return on assets Because it has no debt outstanding the rate of return on equity is also 10 percent The corrpany follows a dividend policy of paying a cash dividend at the end of each year equal to that year39s net income Visual 39 s fiscal year ends on Decenber 31 and the current year is 2003 100000 x 10 BEPS 100 10000 NOTE If ROR lt 10 BEPS lt 100 If ROR gt 10 BEPS gt 100 WEIGHTED AVERAGE SHARES OUTSTANDING IN DENOMINATOR OF BEPS 2Rate of return approach explains why shares must be weighted in denominator of BEPS EXAMPLE 2 EXAMPLE 2 Assune the sane facts as in EXAMPLE 1 in addition to the follow39ng transaction Ch July 1 2003 Visual issues 1000 shares of connDn for 10000 In this overly sinplistic exanple both the theoretical and actual narket price of Visuals connDn stock is 10 per share Because Visual earns a 10 percent rate of return on assets net incone for 2003 is 10500 calculated as follows hbt incone 10 x 100000 10 x 10000 x 12 10500 Issue on 71 of 1000 shares for 10K 10K 10K x 10 x 12 BEPS 100 10K 1000 x 12 NOTE If shares not weighted BEPS lt 1 and would signal decline in profitability Note also that in following years EPS would remain at 100 110K x 10 11000 BEPS 100 11000 shares STOCK DIVIDENDS AND STOCK SPLITS 3Rationale for retroactive treatment of stock dividends and stock splits EXAMPLE 3 EXAMPLE 3 Assur39r39e the facts in EXAMPLE 2 Also assume that on Decenber 30 2003 Visual issues 2200 shares as a 20 stock dividend 10500 BEPS 833 12 x 10000 x k 12 x 11000 x a 12600 NOTE If retroactive treatment were not required individual investors would think their share of earnings had gone up shares went from 105 to 132 x 100 132 instead of the historical 105 Also next year BEPS is 83 1100013200 shares Retroactive treatment thus increases predictability of future earnings and cash flows FOR DILUTED EARNINGS PER SHARE DEPS IFCONVERTED METHOD 4Rate of return approach enhances understanding of the logic of if converted method including actual conversions EXAMPLE 4 No conversions EXAMPLE 4 Assurr39e the sarr39e facts from EXAMPLE 1 Visual has reported EPS of 100 each year from 1983 through 2002 At the beginning of 2003 Visual decides to obtain Afi nanci al leverage by issuing for 50000 5 percent convertible debt with a maturity value of 50000 Assets purchased with the cash proceeds also earn a 10 percent rate of return Financial leverage means that a corrpany is earning a higher rate of return on assets than the interest rate paid on borrowings to finance the assets earning the return The debt is convertible at the option of the debt holders into 5000 shares of commn stock DJl39l ng 2003 none of the bonds were converted to commn stock Net income for 2003 was 12500 taxes are ignored for sirrplicity lncorr39e before interest 10 x 150 000 15 000 Inter est expense 05 x 50000 g2 500 12500 BEPS 125 10000 12500 2500 DEPS 100 10000 5000 Note If conversion actually occurred next year BEPS next year would be 100 not 125 Investors would like to know what the effect of conversion is before the fact rather than after the fact Interest saved 2500 EPIS bonds Shares issued 5000 50 NOTE The 50 tells us that these convertible bonds have the potential to reduce BEPS to a number approaching 50 STOCK OPTIONS 5Rate of return approach in EXAMPLE 5 illustrates a alternative methods of Aplaying like with the assumed exercise of stock options including the treasury stock method and b Aspects of treasury stock method Logical is exercise likely Mechanical dilutive vs antidilutive Treasury stock method if options are Ain the money ie if the exercise price is below the market price 1 Assume options exercised and shares issued 2 Assume proceeds from shares issued used to purchase own shares in the market at the average market price 3 Difference between shares issued and shares purchased included in the denominator of DEPS No numerator effect Treasury stock method not used if options are out of the money ie if the exercise price is above the market price When the options are out of the money conversion is not probable
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