Income Statement for CharmCorp:

2008 2009

Total sales 600 540

Cost of sales - 532 - 488

Gross Profit 68 52

Selling, general,

and administrative expenses - 36 - 21

Research and development - 4 - 5

Depreciation and amortization - 5 - 5

Operating Income 23 21

Other income 1 5

Earnings before interest

and taxes (EBIT) 24 26

Interest income (expense) - 7 - 7

Pretax income 14 19

Taxes - 4 5

Net Income 10 14

Consider the above Income Statement for CharmCorp. All values are in millions of dollars. If CharmCorp. has 4 million shares outstanding, and its managers and employees have stock options for 2 million shares, what is its diluted EPS in 2008?

A) $3.5

B) $2.5

C) $1.67

D) $2.33

E) $4.00

F) None of the above

The answer is C.

Explanation:

When a company has stock options, warrants outstanding, diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from exercise to repurchase as many shares of common stock as possible at the average market price of common stock during the period.

As a result, the number of shares outstanding would increase by the incremental number of shares issued

So let's start with the calculation:

Diluted EPS under this method is

=Net income/number of shares outstanding plus new shares that would have been issued at option

Common stock outstanding is 4 million shares

Option is 2 million shares

So, total number of outstanding shares is 4+2 = 6million.

Net income for 2008 is $10million

Therefore EPS equals:

$10/6miillion shares

= $1.67