Example 6 Diluted EPS – Convertible BondsConvertible bonds1 January Shares in issue 1,000,000Profit for the year ended 31 December $200,00031 March Company issues $200,000 6% convertible bonds Terms of conversion:100 shares/$100 if within five years110 shares/$100 if after five yearsAn equivalent loan without the conversion rights would have required an interest rate of 8%.The company’s tax rate is 33%Basic EPS: $200,000/1,000,000 = $0.20Required:Calculate diluted EPS.

To calculate the diluted EPS, we need to adjust the net income and the number of shares for the potential conversion of the bonds.

Step 1: Calculate the interest expense saved due to the lower interest rate on the convertible bonds. This is the difference between the interest that would have been paid on an equivalent loan without conversion rights and the interest actually paid on the convertible bonds.

Interest saved = ($200,000 * 8$200,000 * 6%) = $4,000

Step 2: Adjust the interest saved for tax. The interest expense is tax deductible, so we need to reduce the interest saved by the tax that would have been saved if the higher interest had been paid.

After-tax interest saved = $4,000 * (1 - 33$2,680

Step 3: Adjust the net income for the after-tax interest saved. This gives us the adjusted net income that would have been earned if the bonds had been converted.

Adjusted net income = $200,000 +$2,680 = $202,680

Step 4: Calculate the additional shares that would have been issued if the bonds had been converted. We use the conversion terms of the bonds to do this.

Additional shares = $200,000 /$100 * 100 = 200,000 shares

Step 5: Adjust the number of shares for the potential conversion of the bonds. This gives us the diluted number of shares.

Diluted shares = 1,000,000 + 200,000 = 1,200,000 shares

Step 6: Calculate the diluted EPS. This is the adjusted net income divided by the diluted number of shares.

Diluted EPS = $202,680 / 1,200,000 =$0.169

So, the diluted EPS is $0.169.