# Basic EPS Shares

Stanley Corp. had 100,000 shares of common stock outstanding throughout 2004. It also had 20,000 stock options with an exercise price of \$20 and another 20,000 options with an exercise price of \$28. The average market price for the company’s stock was \$25 throughout the year. The stock closed at \$30 on December 31, 2004. What are the number of shares used to calculate diluted earnings per share for the year? A) 104,000. B) 105,000. C) 110,000. D) 120,000. Ans: Only the stock options with an exercise price of \$20 are dilutive. The additional shares of 4,000 (20,000 − [(20,000 × 20) / 25]) are added to the 100,000 common shares outstanding. Why are the additional shares calculated this way?

Because dilutive stock options are calculated using the “treasury stock method.” Think of it this way, the company is short calls and the optionholders are long calls. So if the price is in the money (average market price is higher than the option strike price), the optionholders will exercise their right to buy shares at the strike price (in this case it will be \$20/share) from the company. The company receives \$20*20,000 options = \$400,000 dollars. At the same time, there is an increase of shares by 20,000 (the optionholders now have shares). The treasury stock method calculation involves the following (which may or may not actually occur but is an assumed method): The company takes the proceeds of the \$400,000 and uses it to buy back shares on the market (this is helpful to current shareholders, as their shares become less diluted). The market is the average market price So \$400,000/(\$25/share) = 16,000 shares So an increase of 20,000 shares occurs and a reduction of 16,000 shares occurs. The net effect is an increase of 4,000 shares. If you look at the formula provided in the answer, you will see that the above calculations are the exact method if you work out the math.

option is dilutive only if strike price < average market price. in this case, the option with strike price of 20 is dilutive. the number of shares increased from the option = number of options * (average mkt price - strike price)/average mkt price = 20,000 * (25-20)/25 = 4,000

btw the topic should be dilutive EPS. there’s no change in number of shares when calculating basic EPS.

Oh, right…I remember now. Just one of those things that my brain decided not to retain. Thanks for your thorough explanation!

So, the answer is A right ?

yep its A