A. This answer incorrectly uses the market rate to calculate the interest on the bonds. For purposes of calculating DEPS, we need to know only the stated rate for the bond because this determines how much cash was paid, which will be the amount of the tax deduction for interest for the company. See the correct answer for a complete explanation.
B. In order to calculate DEPS, we need to assume that the bonds had been converted at the beginning of the year and calculate what the EPS Effect would have been if this had happened. If the bonds had been converted, there would have been 20,000 additional shares outstanding during the year. There also would have been more income available to the common shareholders since interest would not have needed to be paid. The interest saved would have been $16,000 (the $200,000 face amount × the 8% bond rate - we do not care about market rate). However, if they had not paid interest, income would have been higher by $16,000, and they would have had to pay taxes on the $16,000. These taxes would have been $5,440 leaving $10,560 as available to common shareholders. Dividing this by the 20,000, we get an EPS Effect of $.528. This is less than the basic EPS so these convertible bonds are dilutive. We add the $10,560 to the net income of $107,000 and the 20,000 shares to the 80,000 outstanding and we get a new calculation of $117,560 divided by 100,000 shares, giving us a DEPS of $1.18.
C. This answer is incorrect. See the correct answer for a complete explanation.
D. This answer does not increase income available for common shareholders by the saved interest (net of taxes) from the bonds that are assumed to have been converted.
