Options and Dil. EPS

Question: OptionTech Company reported net income of $2.3 million for the year ended 30 June 2009 and had a weighted average of 800,000 common shares outstanding. At the beginning of the fiscal year, the company has outstanding 30,000 options with an exercise price of $35. No other potentially dilutive financial instruments are outstanding. Over the fiscal year, the company’s market price has averaged $55 per share. Calculate the company’s basic and diluted EPS.

While I know the formula for treasury method, I don’t quite get the intuition behind it. Specifically, here are my questions:

a) With exercise price of $35 and 30K options outstanding, OptionTech would get $1,050,000. Now, if it reinvests this money by buying (back) common stock at $55, wouldn’t the average number of outstanding shares go down? The formula states that we need to subtract ($35*30000/$55) = 19,091 shares from 30K shares to get how many additional shares are issued. So, the denominator will be 800K + 30K - 19091. However, I would argue that we should subtract 19090 from 800K because these many shares are being bought back. Isn’t it? I am not quite sure about the idea that WACSO (weighted average com. shares out.) increases by 30K-19090 = 10909.

b) This method also assumes that we are talking about put options and not call option, in which case we would have a negative outflow because OptionTech would have to pay the money to buy the stock. Is this assumption always true ? I looked at Schweser and Curriculum and didn’t find any discussion on call or put options. So, this is another question I thought of discussing.

Can someone please help me? I am a bit stuck.

a) You issue 30,000 shares at $35 apiece, receiving $1,050,000.

We use that $1,050,000 to repurchase shares at $55 apiece; we repurchase 19,091 shares.

Therefore, the outstanding shares have increased by a net of 10,909 (= 30,000 − 19,091).

b) You’re mistaken; these are (essentially) call options, likely owned by employees. They exercise the options to buy the stock.

Thanks S2000magician. I get it now. From investor’s perspective, these are call options. Put option doesn’t make sense because they would buy at $35 and sell at $55.

You’re welcome.