Question

On December 31, 2020, Dow Steel Corporation had 780,000 shares of common stock and 318,000 shares of 10%, noncumulative, nonconvertible preferred stock issued and outstanding. Dow issued a 5% common stock dividend on May 15 and paid cash dividends of $580,000 and $87,000 to common and preferred shareholders, respectively, on December 15, 2021.

On February 28, 2021, Dow sold 68,000 common shares. In keeping with its long-term share repurchase plan, 5,000 shares were retired on July 1. Dow's net income for the year ended December 31, 2021, was $3,000,000. The income tax rate is 25%. Also, as a part of a 2020 agreement for the acquisition of Merrill Cable Company, another 24,000 shares (already adjusted for the stock dividend) are to be issued to former Merrill shareholders on December 31, 2022, if Merrill's 2022 net income is at least $680,000. In 2021, Merrill's net income was $810,000.



As part of an incentive compensation plan, Dow granted incentive stock options to division managers at December 31 of the current and each of the previous two years. Each option permits its holder to buy one share of common stock at an exercise price equal to market value at the date of grant and can be exercised one year from that date. Information concerning the number of options granted and common share prices follows:



Options Granted



Date Granted (adjusted for the stock dividend) Share Price



December 31, 2019 25,000 $ 42



December 31, 2020 20,000 $ 51



December 31, 2021 23,500 $ 50



The market price of the common stock averaged $50 per share during 2021.



On July 12, 2019, Dow issued $1,000,000 of convertible 8% bonds at face value. Each $1,000 bond is convertible into 25 common shares (adjusted for the stock dividend).



Required:



Compute Dow's basic and diluted earnings per share for the year ended December 31, 2021

Answer 1

To compute Dow's basic EPS for 2021, subtract preferred dividends from net income to find the income available for common shareholders, then divide by the weighted average number of common shares. For the diluted EPS, also consider the impact of convertible securities such as bonds and options, and adjust the income and share count accordingly.

Step-by-step explanation:

Calculation of Basic and Diluted Earnings Per Share for Dow Steel Corporation

The calculation of basic earnings per share (EPS) for Dow Steel Corporation for the year ended December 31, 2021, takes into account the net income available to common stockholders and the weighted average number of common shares outstanding during the year. The preferred dividends should be subtracted from net income to determine the net income available to common stockholders. To calculate the weighted average number of common shares outstanding, we need to consider the issuance and retirement of shares, as well as the timing of these events. The diluted earnings per share takes into consideration the potential conversion of convertible securities, such as bonds and options, which would increase the number of shares outstanding.

To calculate the basic EPS:

Subtract the preferred dividends from net income to get the income available to common shareholders.

Calculate the weighted average number of common shares outstanding for the year.

Divide the income available to common shareholders by the weighted average number of shares.

We would then move to compute the diluted EPS:

Add to the net income any convertible security-related expenses, such as bond interest net of tax savings, which were not already accounted for in net income.

Add the additional common shares that would be in circulation if the convertible securities were converted to the weighted average number of shares.

Recalculate the EPS using this new weighted average share count.