Net Income Calculation for Basic EPS | CFA Level 1 Exam Prep

Net Income Calculation

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Question

New Gestalt, Inc., a software firm had a net income of 1.7 million last year. It has 200,000 common shares and 300,000 convertible bonds with face value of 100 outstanding. The convertible bonds carry a coupon of 4% and can be converted one-for-one. The average stock price last year was 39 and the maximum price was 57. The effective interest rate on the convertible debt is 8%. New Gestalt issued 100,000 preferred shares with face value 100 and a coupon of 5% on March

31st of last year. Assume the convertible bonds are dilutive and that New Gestalt faces a 30% tax rate. The number of shares used in Basic EPS equals

________.

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A. B. C. D.

D

Basic EPS considers only the weighted number of common stock outstanding. Therefore, number of shares used in Basic EPS = 200,000.

To calculate the number of shares used in the Basic Earnings per Share (EPS) calculation, we need to consider the weighted average number of common shares outstanding during the period.

Given information:

  • Net Income: $1.7 million
  • Common Shares: 200,000
  • Convertible Bonds: 300,000 with a face value of $100 each
  • Convertible Bonds carry a coupon of 4%
  • Convertible Bonds can be converted one-for-one
  • Average Stock Price last year: $39
  • Maximum Stock Price last year: $57
  • Effective interest rate on the convertible debt: 8%
  • Preferred Shares: 100,000 with a face value of $100 and a coupon of 5%
  • Tax Rate: 30%

To calculate the dilutive effect of convertible bonds on EPS, we need to determine if the convertible bonds would have a dilutive effect on EPS by comparing their conversion value to the net income.

  1. Calculate the conversion value of the convertible bonds: Conversion Value = Number of Convertible Bonds × Conversion Ratio × Average Stock Price Conversion Ratio = 1 (since the bonds can be converted one-for-one)

Conversion Value = 300,000 × 1 × $39 = $11,700,000

  1. Compare the conversion value to net income: If the conversion value is greater than net income, the bonds are dilutive.

$11,700,000 > $1,700,000

Since the conversion value is greater than net income, the convertible bonds are dilutive.

Next, we calculate the weighted average number of common shares outstanding during the period.

Weighted average number of common shares outstanding is calculated as follows:

Weighted average common shares = Common shares + (Convertible Bonds × (1 - Tax Rate))

Weighted average common shares = 200,000 + (300,000 × (1 - 0.30)) Weighted average common shares = 200,000 + (300,000 × 0.70) Weighted average common shares = 200,000 + 210,000 Weighted average common shares = 410,000

Therefore, the number of shares used in the Basic EPS calculation is 410,000.

None of the provided answer choices match the calculated value. It's possible that there is an error in the question or answer choices.

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