Hello. Welcome everyone to our lesson today. In today's lesson, we actually will stay with EPS calculations with diluted earnings per share, but we were actually going to introduce a very special scenario when calculating this diluted earnings per share. Sometimes, the effect of the conversion or the exercise of those potential common shares, would be to increase rather than decrease the EPS. We refer to these types of securities as anti-dilutive securities. Such securities are ignored when calculating both the basic and the diluted earnings per share. Obviously, let's talk about those securities that are converted, that are exercised into stock options, like options, warrants, or rights. Then we're going to go to the convertible securities and talk about anti-dilutive convertible security. Let's start with anti-dilutive options, warrants, or rights. In applying the treasury stock method, which we use in those with respect to those securities, the number of shares assumed repurchased is fewer than the number of shares assumed sold. This is the case anytime the buyback, which is the average market price according to the treasury stock method, is higher than the exercise price of those options or rights. Consequently, there will be a net increase in the number of shares, which is in the denominator, thus, the earnings per share will decline. On the other hand, when the exercise price is higher than the market price or the average market price during the period, then we assume the shares that are sold at the exercise price and repurchased at the market price, would mean buying back more shares than we actually sold. This would produce a net decrease in the number of shares. In this case, the EPS would increase and not decrease. These would have what we refer to as anti-dilutive effect and would not be considered that they will be exercised or not assumed. Actually, it's not going to be only simply that it's not assumed, it's actually not rational. It's going to be rational to the investor to exercise when the market price is actually higher than the exercise price. A rational investor would not exercise options at an exercise price higher than the current market price. Let's go to the anti-dilutive convertible securities. Convertible securities, it's not immediately obvious whether the effect of the conversion would be dilutive or anti-dilutive, because of the assumed conversion would affect both the numerator and the denominator of the EPS calculation. We would discover whether each convertible security was actually dilutive or not, only after including the effect, both in the numerator and the denominator in the calculation and observing the result. If there is a decline, they will dilutive, if not they're anti-dilutive, but actually, there is an easier way that we can use as a shortcut to determine, instead of incorporating that into the EPS and discovering the result, and see whether it is dilutive or not. To determine whether the convertible securities are dilutive and should be included in a diluted earnings per share calculation, we can compare what we refer to as the incremental effect of this conversion. That incremental effect will be described into a fraction. With the EPS fraction, we're going to compare that fraction, the incremental, with the EPS fraction, the calculation, before the effect of any convertible security is concerned. If that incremental effect of the security is higher than the basic EPS or without the conversion, then it is anti-dilutive. A convertible security might seem to be dilutive when looked at individually, but in fact, may be anti-dilutive when included in combination with other convertible securities. This is because the order of entry for including their effects in the EPS calculation, determines by how much or even whether EPS decreases as a result of their assumed conversion. Here, when we tried to decide, we need to remember that our goal is to reveal the maximum potential dilution that might result. Theoretically, we should calculate diluted EPS using every possible combination of potential common shares, to find the combination that yields the lowest EPS, but that's not necessary actually because again, there is a shortcut that we can actually make preferences on the order of how do we enter those or test those dilutive securities. We can use the earnings per incremental share that we calculated, to determine the sequence of including the securities effects in the calculation. We actually include the securities in reverse order, beginning with the lowest incremental effect, that is the most dilutive, followed by the next lowest, and so on. In summary, to determine the order of conversion, we need to follow the following three steps. Number 1, calculate what we refer to as the incremental effect, which we divide the effect of each conversion on the numerator by its effect on the denominator. Number 2, rank the effects from the smallest to the largest. Number 3, convert starting with the smallest and continue as long as the conversion is dilutive. Thank you.
