CFA Practice Question

There are 534 practice questions for this study session.

CFA Practice Question

An analyst has gathered the following information about Artcraft, Inc. for 2015:

  • Net income of $30,000.
  • 5,000 shares of common stock and 500 shares of 8 percent, $90 par convertible preferred stock outstanding during the whole year.
  • Each share of convertible preferred can be converted into 4 shares of common stock.
  • Last year, Artcraft issued at par, $60,000 of par, 6.0 percent convertible bonds, with each of the 60 bonds convertible into 110 shares of the Artcraft common stock.

If Artcraft's effective tax rate is 40 percent, what will Artcraft report as diluted earnings per share (EPS) for 2015?
A. $3.37
B. $3.42
C. $2.36
Explanation: diluted EPS = adjusted earnings after conversion (EAC) / weighted average plus potential common shares outstanding

Step 1: Calculate adjusted EAC preferred dividends = convertible preferred dividends = (0.08)(90)(500) = 3,600, convertible debt interest = (60,000)(0.06)(1 - 0.40) = 2,160, adjusted EAC = (30,000 + 3,600 - 3600 + 2,160) = $32,160

Step 2: Calculate weighted average plus potential common shares outstanding: 5000 + 500 x 4 + 60 x 110 = 13,600.

Step 3: Calculate diluted EPS: diluted EPS = 32,160 / 13,600 = $2.36.

User Contributed Comments 19

User Comment
geet Why do we add and then subtract the convertible preferred DIV? It's been converted to Common stock so there is no dividend. Anybody?
mm04 I think you need to add as part of the income going to the common shares. The answer is wrong?
koushaku It's correct. The convertible preferred div needs to subtracted then re-added in.
(30,000 - 3600) + 3600 + 2160 = 32,160/13,600 = 2.36
sireklove Yes, I agree. The 2004 CFA Level I Candidate Readings says (p38) regarding capital structures with convertible preferred stock: "Preferred dividends are not subtracted from net income in computing the numerator because it is assumed that the convertible preferreds are converted and are outstanding as common stock for purposes of computing EPS."

I believe the answer should be $2.365 as well.
johnsk the convertible preferred should be assumed that they are converted: the income they take should be added back to net income?
mellyg where is 13,600 coming from? Mine is 5,000+2,000+11,000=18,000.
chenyx preferred dividend (3600) should not be added to net income, right?
Mdavid2 I think 2.36 is correct. The net income is before paying the prefered dividends. Thus PD should not be added.
vstolin I absolutely agree. It should be $2.36
We do not need to add preffered dividend since it was not yet subtracted from the Net Income. So by the book it is:
30,000 - 3600 + 3600 + 2160
---------------------------- = 2.36
5000 + 2000 + 6600
dasun how come 6600? isn't 60,000 par value of bonds means 60 shares?
mtcfa there are 60 bonds, the par value of each being $1,000. Each bond converts to 110 shares, so: 60 * 110 = 6600 new shares.
americade I also agree. The preferred dividend is subtracted just like a non-convertible pfd, but the convertible pfd dividend is then added back in on assumed conversion - conclusion: $2.36 is correct.
merrick 5000 common
2000 500*4
6600 60*110
=13600
30000+2160/13600=2.36
miteymouse Can someone explain again why you add and then subtract the 3600 for dividend? Why don't you just add it? Why do you have to subtract it after?
wundac You substract because in calculating the EPS you always substract preferred dividend. However in this case we are calculating diluted earning per share so we need to add it to take into account the effect of the assumed conversion. If we assume that the convertible preferred stocks are converted and reinvested in the company(definition of diluted) then we need to add it back.
cslau83 when calculating EPS we subtract preferred dividends for NON-CONVERTIBLE preferred shares.

For CONVERTIBLE we assumed we don't pay out preferred dividends, hence its "added back" after we subtract.
Lambo83 Net Income - Preferred Divs is the numerator for basic EPS.

For diluted EPS the Preferred Divs will not be paid because they have been converted to common stock.

The answer explanation is just changing from basic to diluted hence (Net Income -Pref Divs) + Pref Divs
weebe Why is convertible debt interest 2160 ? Why are they multiplying (1 - 0.4)
weebe Figured it out. It's because of the tax. Tax is charged on bond interest.
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