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  1. 090A company has net income of Rs 300 crore and 10 crore shares. It also has Rs 500 crore of 6% convertible bonds, convertible at Rs 250 a share. The tax rate is 25%. What is basic EPS, what is diluted EPS on the if-converted method, and what happens to each statement if the bonds actually convert?Accounting flow riddlesHardEquity researchBig Four

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    How many new shares does conversion create?

    Show the worked solution

    Basic EPS is Rs 30.0; diluted EPS is Rs 26.88, about 10% lower. The if-converted method assumes conversion: add back the after-tax interest saved, Rs 30 crore x 0.75 = Rs 22.5 crore, and add 2 crore shares. That gives Rs 322.5 crore over 12 crore shares. On actual conversion, debt falls Rs 500 crore and equity rises Rs 500 crore, interest expense stops, and no cash changes hands.

    What does the if-converted method assume?

    Imagine a friend lent your shop Rs 5 lakh and can choose, any time, to swap the loan for a share of the business. To be honest with your other partners about what each share is worth, you would show the numbers as if the friend has already swapped: no more interest to pay, but one more partner splitting the profit. Diluted EPS shows earnings per share as if every convertible security that would reduce EPS had already converted, adding back the interest it would save and adding the shares it would create.

    The interest is Rs 500 crore x 6% = Rs 30 crore a year. It was tax-deductible, so removing it raises net income by only Rs 30 crore x (1 minus 25%) = Rs 22.5 crore. Conversion creates Rs 500 crore / Rs 250 = 2 crore shares. Diluted EPS is (300 + 22.5) / (10 + 2) = Rs 26.875, which rounds to Rs 26.88.

    The relationship
    Diluted EPS=NI+I(1−t)N+FPc=300+30×0.7510+500250=322.512=26.875\text{Diluted EPS} = \frac{\text{NI} + I(1-t)}{N + \frac{F}{P_c}} = \frac{300 + 30 \times 0.75}{10 + \frac{500}{250}} = \frac{322.5}{12} = 26.875
    NInet income, Rs 300 crore
    Iannual interest on the convertible, Rs 30 crore
    Nexisting shares, 10 crore
    F / P_cface value over conversion price, the new shares
    What it says in wordsAdd the after-tax interest saved to earnings and the conversion shares to the share count.
    Conversion swaps an interest cost for more shares; the shares winRs 30.0Basic EPS300 / 10Rs 26.88Diluted EPS322.5 / 12Earnings +7.5%, shares +20%Earnings per share, existing vs newEach existing share earnsRs 30Each new share bringsRs 11.25= 22.5 / 2Incremental EPS below basic EPS:the convertible is dilutive, so count it
    Conversion lifts earnings by 7.5% but the share count by 20%, because each new share brings only Rs 11.25 of saved after-tax interest against Rs 30 earned by each existing share, so diluted EPS falls to Rs 26.88.

    How do you know whether a convertible dilutes?

    Compare what each new share brings with what each existing share earns. Each conversion share brings Rs 22.5 crore / 2 crore = Rs 11.25 of earnings, far below basic EPS of Rs 30, so including the convertible lowers EPS and it must be counted. If basic EPS were below Rs 11.25, conversion would raise EPS; that security is anti-dilutive and is left out of diluted EPS. The test is per security, so a company with several convertibles ranks them from most to least dilutive.

    What happens to each statement on actual conversion?

    Balance sheet: borrowings fall Rs 500 crore and equity rises Rs 500 crore, split between share capital at face value and securities premium. Total assets do not move; the right-hand side changes its mix and leverage falls sharply. Income statement: from the conversion date, the Rs 30 crore of interest stops, so profit rises Rs 22.5 crore after tax. Cash flow statement: nothing at conversion, because no cash changes hands; it is disclosed as a non-cash transaction. Afterwards, the Rs 30 crore of cash interest is no longer paid. Reported basic EPS after conversion should land close to the diluted EPS already shown, which is why analysts value on the diluted figure.

    Where candidates lose it

    The common error is adding the full Rs 30 crore of interest back to earnings. Interest was tax-deductible, so saving it also loses the tax shield: only Rs 22.5 crore reaches net income. Using Rs 30 crore gives Rs 27.50 instead of Rs 26.88.

    The second loss is the statement walk. Candidates say cash falls by Rs 500 crore to repay the bond, but conversion repays nothing in cash: the bondholders take shares instead. Debt becomes equity, the balance sheet total stays put, and the cash flow statement shows nothing on the day.

    What the interviewer asks next

    • At what level of net income would this convertible become anti-dilutive?
    • The company also has options on 1 crore shares at Rs 200, and the share price is Rs 300. How do they enter diluted EPS?
    • Why might a company prefer issuing a convertible to straight debt, and what does it give up?