convertible prefferd stock

CFA Level I FRA
#1

It is my first post here on the forum, so I would like to say Hallo. 1st of June is approaching, so I am doing tests from Schwesser QB, and have found something that bothers me.

Qustion no 97829 says that we should add to earnings available to common shareholders dividends on convertible preffered stock,

In calculating the numerator for diluted earnings per share, the _ dividends on convertible preferred stock are _:

A) added to earnings available to common shareholders with an adjustment for taxes.

B) added to earnings available to common shareholders without an adjustment for taxes.

C) subtracted from earnings available to common shareholders without an adjustment for taxes.

Your answer: C was incorrect. The correct answer was B) _ added to earnings available to common shareholders _ without an adjustment for taxes.

whereas Question no 97755 in its explanation says that we should subtract them. So I am confused.

Lawson, Inc.’s net income for the year was $1,060,000 with 420,000 shares outstanding. Lawson has 2,000 shares of 8%, $1,000 par value convertible preferred stock that were outstanding the entire year. Each share of preferred is convertible into 50 shares of common stock. Lawson’s diluted earnings per share are closest to:

A)

$1.94.

B)

$2.04.

C)

$2.14.

Lawson’s basic EPS ((net income – preferred dividends ) / weighted average common shares outstanding) is ($1,060,000 – (2,000 × $1,000 × 0.08)) / 420,000 = $2.14. To calculate diluted EPS the convertible preferred shares are presumed to have been converted, the preferred dividends paid are added back to the numerator of the EPS equation, and the additional common shares are added to the denominator of the equation. Lawson’s diluted EPS is $1,060,000 / (420,000 + 100,000) = $2.04.

Any Explanation of that particular case is welcome.

MB

#2

For basic EPS the numerator is net income – preferred dividends (whether paid or not).

The idea behind diluted EPS is to see what would happen if the preferred stock were converted to common stock. Two things would happen: the number of common shares would increase, and the preferred dividend would not have to be paid (because there would be no preferred stock: it would have been converted to common stock).

So, the numerator for diluted EPS (with convertible preferred) is:

(net income – preferred dividends) + preferred dividends = net income

You add the preferred dividend to the basic EPS numerator; in essence, you simply don’t subtract it from net income. Note that dividends are not tax-deductible, so there’s no adjustment for taxes when they’re subtracted for basic EPS, nor when they’re readded for diluted EPS.

The denominator will increase by the number of common shares into which the preferred can be converted. You do the new EPS calculation and check to see if the new number is less than the old number.

#3

Thanks a lot for an indepth explenation.

#4

My pleasure.