Intermediate II Ch. 16

Dilutive Securities Examples
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Warrants 3 situations1) to make security more attractive - ooh la la 2) existing stockholders have a preemptive right to purchase common stock first 3) to executives and employees as a form of compensationWarrants LifeGenerally 5 years Sometimes 10Warrant proceeds allocatedbetween the two securitiesWarrant allocation based onfair market valueTwo methods of Warrant allocation1) proportional 2) incrementalIncremental Methodcompany cannot determine fair value of either the warrants or the bonds -use security for which fair value can be determined -allocate remainder of the purchase price to the security for which it does not know fair valueDetachable warrants involves two securitiesA debt security A warrant to purchase common stockNondetachable warrants-DO NOT require an allocation of proceeds -companies record the entire proceeds as debt *if you can't detach a warrant, why would it have a separate value?Stock Rightexisting stockholders have the right (preemptive privilege) to purchase newly issued shares in proportion to their holdings -price is normally less than current price of the shares -companies make only a MEMO (no entry)Stock Optiongives key employees option to purchase common stock at a given price over extended period of timeEffective compensation programs are ones that:1. base compensation on performance 2. motivate employees 3. help retain executives and recruit new talent 4. maximize employee's after-tax benefit 5. use performance criteria over which employee has controlCompensation issuesvaluation (how to determine comp expense) expense recognition principleCompensation plans1) restricted stock awards 2) stock options 3) employee share purchase plansDetermining Compensation Expensecompensation expense based on the fair value of the options expected to vest on the date they grant the options to the employeeAllocating Compensation Expenserecognizes compensation expense in the periods in which its employees perform the service-the service periodRestricted Stocktransfer shares of stock to employees, subject to an agreement that the shares cannot be sold, transferred, or pledged until vesting occursMajor advantages of Restricted Stock1. never becomes completely worthless 2. generally results in less dilution to existing stockholder's 3. better aligns employee incentives with company incentivesUnearned Compensation reported asa component of stockholder's equity in the balance sheetEmployee Stock-Purchase Plansconsidered compensatory unless they satisfy all three conditions presented below: 1. substantially all full-time employees may participate on an equitable basis 2. the discount from market is small 3. the plan offers no substantive option featureEarnings per shareindicates the income earned by each share common stockCompanies report EPS for onlyCommon StockIncome statement contains intermediate component (discontinued operations)EPS: income from continuing operations Loss from discontinued operations, net of tax ( ) Net incomeEarnings Per Share - Simple Structurecommon stock; no potentially dilutive securitiesEPS - complex structureincludes securities that could dilute EPSDilutivemeans the ability to influence the EPS in a downward directionEPS formula(Net Income - preferred dividends)/ W/A number shares outstandingEPS Conceptsinvestors care more about EPS than any other financial metric - why we spend so much time on EPSMost common EPS number reporteddiluted EPSWhy is EPS diluted?by taking into account assumed exercise/conversion of other securities into common stockShareholders want to knowthe extent of the reduction in EPS if dilution takes placeDilution is hypothetical question"What if it got converted in the beginning of the year?"Diluted earnings per share treats _____________ as convertedconvertible bonds preferred stockDiluted effect of convertible securities is measured by the _______________ method"if converted"Dilutive effect of options/warrants is measured by the _____________________ method"treasury stock"Complex Capital structure exists when a business hasconvertible securities options, warrants, or other rightsantidilutiveif diluted securities do not take EPS in a downward motion, instead, in an upward motionIf converted method numerator effectinterest x (1-tax rate)Diluted EPS - Treasury-Stock method1. the exercise the options or warrants at the beginning of the year (or date of issue if later) 2. that the company uses those proceeds to purchase common stock for treasuryContingent shares are issued as a result of the1. passage of time condition or 2. upon attainment of a certain earnings or market price levelAntidilution Revisitedignore antidilutive securities in all calculations and in computing diluted EPSA company should show per share amounts for:-income from continuing operations -income before extraordinary items -net income