Question from Schweser on diluted EPS (pg. 70 in fin. rep.)

Page 70 of the Schweser notes on Fin. Reporting has Example #4, which asks about diluted EPS.

My question is basically this. Aren’t the convertible bonds non-dilutive? why would they be in diluted EPS if they aren’t dilutive?? Also, if you ARE converting the bonds to stock, shouldn’t you factor the increased tax liability in the numerator???

I hate this question!

  1. Not sure your thinking behind convertible bonds being non-dilutive. Remember, in this particular case we are assuming all potential convertable securities are converted. 2) To be honest, I hadn’t thought of the tax liability question. If you are converting one security to another, without cashing those securities and realizaing a taxable gain, I don’t see how there would be a liability involved. Even a deferred tax liability? I’m not positive on this, anyone weigh in?

You are assuming that the converts are being swapped for equity and therefore # of shares O/s increase and results in lower EPS in most cases unless anti dilutive. If you are converting bonds into stock , then you would add back the after tax interest cost that has been deducted from net income because you will not be paying interest anymore. Not sure where you are going with the tax liability. To the firm, there is no cap gain or loss. Cap gain or loss would only accrue to the holder of the convert if for e.g the current market price is higher than the convert price. That is my understanding.