Dilutive Securities

Dilutive securities are "hybrid securities" that have both debt and equity characteristics. They combine:

(1)  an unconditional receivable/payable (the debt attribute) with

(2)  a financial option contract that, if exercised, enables the holder to obtain an equity interest in the issuing firm.

Example: 

The stock warrants can be used to purchase the issuing company's stock at a fixed price.

These compound financial instruments are called dilutive securities because if the option is exercised, additional common stock is issued and this causes a decrease, or dilution in earnings per share.

Types of Dilutive Securities

• Executive stock option   An executive stock option is a special type of warrant.  An executive granted a stock option has the right to:
  -     purchase a fixed number of shares of her company's stock
  -     at a fixed exercise price (The exercise price is usually set equal to the market price of the stock on the date the options are granted.)
  -     during a fixed time period (usually five to ten years).
  
  
  Stock option plans are an effective means of conveying an ownership interest in the firm to its executives.  This motivates the executives to act in the shareholders' interest. 
• Stock Warrants are certificates that entitle the holder to acquire shares of stock at a certain price within a stated period. 
• Convertible Debt  gives the holder the option of converting the bond or note into a fixed number of common shares within a specified time period, typically 10 years.  
• Convertible Preferred Stock is like convertible debt.  It gives the holder the option of converting the preferred shares into a fixed number of common shares within a specified time period. 
  
  
  If a security after conversion causes the EPS figure to increase rather than decrease, such a security is an anti-dilutive security, and it should be excluded from the computation of the dilutive EPS.
  
  For example, assume that the company XYZ has a convertible bond issue: 100 bonds, $1,000 par value, yielding 10%, issued at par for the total of $100,000. Each bond can be converted into 50 shares of the common stock. The tax rate is 30%. XYZ's weighted average number of shares, used to compute basic EPS, is 10,000. XYZ reported an NI of $12,000, and paid preferred dividends of $2,000.
  
  What is the basic EPS? What is the diluted EPS?
  
  1) Compute basic EPS:
  i. Basic EPS = (12,000 - 2,000) / (10,000) = $1.00
  
  2) Compute diluted EPS:
  i. Find the adjustment to the denominator: 100 * 50 = 5,000
  ii. Find the adjustment to the numerator: 100 * $1000 * 0.1 * (1 - 0.3) = $7,000
  
  3) Find diluted EPS:
  i. Diluted EPS = (12,000 - 2,000 + 7,000) / 10,000 + 5,000 = $1.13
  
  If the fully dilused EPS > basic EPS, then the security is antidilutive. In this case, Basic EPS = $1.00 is less than the fully diluted ESP, and the security is antidilutive.

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