EPS QUESTION TAKEN FROM PRIOR FINAL

Question 1

Avatar Ltd is in the business of making cosmetics. Avatars main business strategy is product
differentiation by selling high-end cosmetic products targeted at ladies in the age group from
20 to 40 years old.
For its financial year ended 31 December 2008, Avatar Ltd had 450,000 common shares
outstanding and reported a basic EPS of $2.00. After taking into consideration of the dilutive
effects of its employee stock options plan, Avatar Ltd also reported a diluted EPS of $1.875.
Avatars CEO, Ms. Sally, decided to stop its employee stock options plan in 2009. However,
there were still 50,000 unvested stock options at the beginning of 2009. At the time of the
grant, each option permits its holder to buy one share of common stock at an exercise price of
$25.00. No employee exercised their options in 2009.
To intensify its research and development of new products, Ms. Sally has decided to
aggressively raise funds in 2009. On 1 January 2009, Avatar Ltd issued 500,000 cumulative
preference shares at $20.00 per share. The preference shares carry a dividend of $0.24 per
share. No preferred dividends have been paid since issuance.
On 31 August 2009, Avatar decided to issue additional 50,000 common shares at $25.00 per
share. On 1 December 2009, Avatar issued a 20% stock dividend to its common shareholders.
Avatar reported a net income (before tax) of $500,000 for the financial year ending 31
December 2009. It is subjected to the corporate tax rate of 20%. The average market price of
Avatars common share in 2009 is $22.00.
On 1 July 2009, Avatar issued 10-year, 4% convertible bonds with face value of $250,000 at
104. The interest payment is to be made semi-annually. The conversion feature was that each
$5 bond could be exchanged for 1.2 ordinary share as of the end of the year,. Similar bonds
without the convertible feature were sold at par for $250,000. No convertible bonds have
been exchanged for ordinary shares since issuance.

Required

Ms. Sally has asked for your assistance to prepare Avatars 2009 financial report.
Compute Avatars basic and diluted earnings per share for the year ended 31
December 2009. In addition, report the 2008 comparative basic and diluted earnings
per share. Show your workings.

(This page is deliberately kept blank to separate the question and the solution)

SOLUTIONS
Note for 2008 numbers in 2009 statement:
Net Earnings after tax

= Basic EPS * Common shares outstanding

= $2.00 * 450,000
= $900,000

Total Shares for Diluted EPS = Net Earnings after tax / Diluted EPS
= $900,000 / 1.875
= 480,000
Comparative Basic EPS

= $900,000 / (450,000 * 1.2)

= $1.667

Comparative Diluted EPS

= $900,000 / (480,000 * 1.2)

= $1.563

For 2009 numbers in 2009 statement:

Explanation
Basic earnings and shares
Increment in shares (options)
Tentative DEPS1 amounts
Bond interest expense savings
Increment in shares (bonds)
Diluted earnings and shares

Earnings
$280,000a

$280,000
4,000 d

Shares
560,000b
c
0
560,000

30,000e
590,000

$284,000

Earnings
= Per Share
= $0.50 Basic
= $0.50 DEPS1

= $0.481 DEPS

$280,000 = $400,000 (net income after tax) - $120,000 ($0.24 dividend * 500,000 shares)
Since preferred dividends are cumulative, they have to be accounted for regardless of payment.

Weighted average shares:

450,000 * 8/12 *120% = 360,000

500,000 * 4/12*120% = 200,000
Weighted average
= 560,000

Increment due to share options: 0 due to the fact that average market price is lower than exercise
price. No marks awarded if students do not explain this section.

Interest savings due to convertible bonds: $250,000 * 4% * 6 / 12 * 80% = 4,000.

Convertible bonds have both a liability element and an equity element. It's obvious that only the
liability element yields interest expense. The interest expense should be computed as the net book
value*effective interest rate*half year*(1-tax).
Since "Similar bonds without the convertible feature were sold at par for $250,000", the net book
value of the liability element is 250,000. Therefore, we shall use 250,000 as a basis to compute the

interest expense. Because the liability element is issued at par, the effective interest rate should be
equal to the coupon rate of 4%.
e

Increment due to convertible bonds: 1.2 * $250,000 / 5 * 6 / 12 = 30,000