Ch3 Lecture 2 2022-2023 Finance Lecture Notes PDF

Learning Objective 4 Compute basic earnings per share. LO 4 Copyright ©2020 John Wiley & Sons, Inc. 1 Basic Earnings per Share Earnings per share - income earned by each ordinary share. Companies report earnings per share only for ordinary shares. When the i...

Learning Objective 4 Compute basic earnings per share. LO 4 Copyright ©2020 John Wiley & Sons, Inc. 1 Basic Earnings per Share Earnings per share - income earned by each ordinary share. Companies report earnings per share only for ordinary shares. When the income statement contains discontinued operations, companies are required to report earnings per share from continuing operations and net income on the face of the income statement. ILLUSTRATION 16.13 LO 4 Copyright ©2020 John Wiley & Sons, Inc. 2 Earnings Per Share—Simple Capital Structure Simple Structure Only ordinary shares; no potential ordinary shares upon conversion or exercise. Complex Structure Includes securities (potential ordinary shares) that could have a dilutive effect on earnings per ordinary share. “Dilutive” means the ability to influence E P S in a downward direction. LO 4 Copyright ©2020 John Wiley & Sons, Inc. 3 EPS—Simple Capital Structure Preference Share Dividends Subtracts the current-year preference share dividend from net income to arrive at income available to ordinary shareholders. Net Income − Preference Dividends Earnings per Share = Weighted - Average Ordinary Shares Outstanding ILLUSTRATION 16.14 Preference dividends are subtracted on cumulative preference shares, whether declared or not. LO 4 Copyright ©2020 John Wiley & Sons, Inc. 4 EPS—Simple Capital Structure Weighted-Average Ordinary Shares Outstanding (1 of 2) Companies must weight the shares by the fraction of the period they are outstanding. When share dividends or share splits occur, companies need to restate the shares outstanding before the share dividend or split. LO 4 Copyright ©2020 John Wiley & Sons, Inc. 5 EPS—Simple Capital Structure Shares Outstanding, Ending Balance Illustration: Franks Inc. has the following changes in its ordinary shares during the year. ILLUSTRATION 16.15 Franks then computes the weighted-average number of shares outstanding. LO 4 Copyright ©2020 John Wiley & Sons, Inc. 6 EPS—Simple Capital Structure Weighted-Average Ordinary Shares Outstanding (2 of 2) ILLUSTRATION 16.16 LO 4 Copyright ©2020 John Wiley & Sons, Inc. 7 Share Dividends and Share Splits Shares Outstanding, Ending Balance Illustration: Sabrina Company has the following changes in its ordinary shares during the year. ILLUSTRATION 16.17 Sabrina then computes the weighted-average number of shares outstanding. LO 4 Copyright ©2020 John Wiley & Sons, Inc. 8 Share Dividends and Share Splits Weighted-Average Ordinary Shares Outstanding— Share Issue and Share Dividend Illustration: Sabrina Company has the following changes in its ordinary shares during the year. ILLUSTRATION 16.18 LO 4 Copyright ©2020 John Wiley & Sons, Inc. 9 Comprehensive Example Shares Outstanding, Ending Balance Illustration: Diaz SA has income from continuing operations of R$580,000 and a gain on discontinued operations, net of tax, of R$240,000. It has declared dividends of R$1 per share on 100,000 shares of preference shares outstanding. Diaz also has the following changes in its ordinary shares outstanding during 2022. ILLUSTRATION 16.19 LO 4 Copyright ©2020 John Wiley & Sons, Inc. 10 Comprehensive Example Weighted-Average Ordinary Shares Outstanding ILLUSTRATION 16.20 LO 4 Copyright ©2020 John Wiley & Sons, Inc. 11 Comprehensive Example - Computation of Income Available for Ordinary Shareholders Diaz then divides the weighted-average ordinary shares into income from continuing operations and net income to determine earnings per share. It subtracts its preference dividends of R$100,000 from income from continuing operations (R$580,000) to arrive at income from continuing operations available to ordinary shareholders of R$480,000. ILLUSTRATION 16.21 LO 4 Copyright ©2020 John Wiley & Sons, Inc. 12 Comprehensive Example Earnings per Share, with Gain on Discontinued Operations Diaz must disclose the per share amount for gain on discontinued operations (net of tax) either on the face of the income statement or in the notes to the financial statements. ILLUSTRATION 16.22 LO 4 Copyright ©2020 John Wiley & Sons, Inc. 13  Learning Objective 5 Compute diluted earnings per share. LO 5 Copyright ©2020 John Wiley & Sons, Inc. 14 Diluted Earnings per Share Complex Capital Structure Exists when a corporation has convertible securities, options, warrants, or other rights that upon conversion or exercise could dilute earnings per share. Company reports both basic and diluted earnings per share. LO 5 Copyright ©2020 John Wiley & Sons, Inc. 15 Diluted Earnings per Share Relation Between Basic and Diluted EPS Diluted EPS includes the effect of all potential dilutive ordinary shares that were outstanding during the period. ILLUSTRATION 16.23 Companies will not report diluted EPS if the securities in their capital structure are antidilutive. LO 5 Copyright ©2020 John Wiley & Sons, Inc. 16 Diluted EPS – Convertible Securities If-Converted Method Measure the dilutive effects of potential conversion on E PS using the if-converted method. This method for a convertible bond assumes: 1. the conversion at the beginning of the period (or at the time of issuance of the security, if issued during the period), and 2. the elimination of related interest, net of tax. LO 5 Copyright ©2020 John Wiley & Sons, Inc. 17 Comprehensive Example—If-Converted Method Illustration: Mayfield Ltd. has net income of £210,000 for the year and 100,000 weighted-average ordinary shares outstanding during the same period. The basic earnings per share is therefore £2.10 (£210,000 ÷ 100,000). The company has two convertible debenture bond issues outstanding. One is a 6 percent issue sold at 100 (total £1,000,000) in a prior year and convertible into 20,000 ordinary shares. Interest expense for the current year related to the liability component of this convertible bond is £62,000. The other is a 7 percent issue sold at 100 (total £1,000,000) on April 1 of the current year and convertible into 32,000 ordinary shares. Interest expense for the current year related to the liability component of this convertible bond is £80,000. The tax rate is 40 percent. LO 5 Copyright ©2020 John Wiley & Sons, Inc. 18 Comprehensive Example—If-Converted Method Starting Point When calculating Diluted EPS, begin with Basis EPS. LO 5 Copyright ©2020 John Wiley & Sons, Inc. 19 Comprehensive Example—If-Converted Method Computation of Adjusted Net Income ILLUSTRATION 16.24 LO 5 Copyright ©2020 John Wiley & Sons, Inc. 20 Comprehensive Example—If-Converted Method Computation of Weighted-Average Ordinary Shares ILLUSTRATION 16.25 LO 5 Copyright ©2020 John Wiley & Sons, Inc. 21 Comprehensive Example—If-Converted Method Earnings per Share Disclosure ILLUSTRATION 16.26 LO 5 Copyright ©2020 John Wiley & Sons, Inc. 22 If-Converted Method Other Factors The conversion rate on a dilutive security may change during the period in which the security is outstanding. In this situation, the company uses the most dilutive conversion rate available. For Convertible Preference Shares the company does not subtract preference dividends from net income in computing the numerator. Why not? Because for purposes of computing E P S, it assumes conversion of the convertible preference shares to outstanding ordinary shares. LO 5 Copyright ©2020 John Wiley & Sons, Inc. 23 If-Converted Method Example EPS with Preference Shares Illustration (EPS with Preference Shares): On January 1, 2022, Lund Company issued €1,000,000 of 6% convertible preference shares were issued. Each €100 preference share is convertible into 5 ordinary shares of Lund. Lund’s net income in 2022 was €240,000, and its tax rate was 40%. The company had 100,000 ordinary shares outstanding throughout 2022. Instructions: Compute diluted earnings per share for 2022. LO 5 Copyright ©2020 John Wiley & Sons, Inc. 24 If-Converted Method Example Computation of Basic EPS Illustration: Compute diluted EPS for 2022. When calculating Diluted EPS, begin with Basis EPS. Basic EPS Net income £240,000 − Pfd.Div.£60,000 * = £1.80 Weighted-average shares = 100,000 * £1,000,000 x 6% = £60,000 dividend LO 5 Copyright ©2020 John Wiley & Sons, Inc. 25 If-Converted Method Example Diluted EPS Illustration: Compute diluted EPS for 2022. When calculating Diluted EPS, begin with Basis EPS. Diluted EPS LO 5 Copyright ©2020 John Wiley & Sons, Inc. 26 If-Converted Method Example Antidilutive Preference Shares Illustration (variation): Assume each share of preferred is convertible into 3 shares of common stock. LO 5 Copyright ©2020 John Wiley & Sons, Inc. 27