Chartered Financial Analyst (CFA) Level 1 Practice Exam

What additional consideration is included in the Diluted EPS calculation compared to Basic EPS?

1. After-tax interest on ordinary shares outstanding

2. Common stock dividends

3. Additional share buybacks

4. Unrealized gain on investments

The correct answer is: After-tax interest on ordinary shares outstanding

The calculation of Diluted Earnings Per Share (EPS) takes into account the potential dilution of earnings per share that could occur if all convertible securities were exercised. This includes convertible debt and potential shares from stock options or restricted stock units. In the context of the choice regarding "after-tax interest on ordinary shares outstanding," it's essential to note that the diluted EPS formula adjusts net income by adding back the after-tax interest expense related to convertible securities. This is because the interest expense would not have been incurred if those securities had been converted into equity, hence this adjustment provides a clearer picture of what the earnings per share would be if all convertibles were exercised. Common stock dividends are part of the basic EPS calculation and do not change regarding dilution since they are already considered, which makes this option inaccurate for distinguishing between basic and diluted EPS. Additionally, additional share buybacks do not apply to diluted EPS as they relate to the shares outstanding rather than the potential dilution from convertible securities. Unrealized gains on investments are also unrelated to the calculation of EPS and would not influence either basic or diluted calculations. Thus, the inclusion of after-tax interest related to convertible securities sets diluted EPS apart from basic EPS, reflecting the potential impact of all dilutive securities on the earnings available to