How accurate is the Treasury stock method method in real life?

CFA Level I FRA
#1

Hey guys. Going through the diluted EPS section, and reviewed the Treasury stock method. Pretty simple stuff, but I was wondering how “accurate” this method is in reality.

Using the Schweser example:

“Baxter Company has 5,000 shares outstanding all year. Baxter had 2,000 outstanding warrants all year, convertible into one share each at $20 per share. The year-end price of Baxter stock was $40, and the average stock price was $30. What effect will these warrants have on the weighted average number of shares?”

Using the Treasury stock method, the “extra shares” added to the EPS denominator is 2000 - (20 x 2000) / 30 = 667. So EPS would be (Earnings) / (5000 + 667)

However, in reality, wouldn’t it have been more accurate to calculate the EPS as (Earnings + 20 x 2000) / (5000 + 2000)?

As in, the company would get an extra “cash profit” by the employee/investor “buying” the stocks at $20 x 2000. In “payment”, the company would have to issue another 2000 common stocks.

This is not strictly a CFA exam question, given the method they want you to use (treasury stock method) is pretty clear, but I was just curious about the accuracy.

Thanks.

#2

Accuracy in what sense?

When computing fully diluted EPS, all of your transactions are hypothetical: convertible bonds would have been converted at the beginning of the year, stock options or warrants would have been exercised at the beginning of the year, and so on. In fact, none of those transactions took place.

If the warrants were exercised at the beginning of the year, and if the company had bought back as much stock as it could (from the proceeds) at the average stock price for the year, then the calculation is perfectly accurate: you’re doing exactly what you hypothesized (and without any transaction costs).

#3

“and if the company had bought back as much stock as it could (from the proceeds) at the average stock price for the year”

Gotcha. That makes sense. Thanks.

#4

My pleasure.