McManus Inc. reported net earnings of $800,000 for the year. McManus has 200,000 shares of common stock outstanding all year. On March 31, the company granted 40,000 stock options that allow employees to purchase 40,000 shares for $15 each. The company stock has averaged $20 in the market during the year. Compute the basic and diluted EPS.

Question

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Basic EPS is calculated as net earnings divided by the number of shares outstanding, which is $800,000 / 200,000 = $4.00. For diluted EPS, the stock options are considered. The options are "in the money" since the exercise price ($15) is less than the average market price ($20). The treasury stock method is used to calculate the additional shares: 40,000 options x ($20 - $15) / $20 = 10,000 additional shares. Thus, diluted EPS is $800,000 / (200,000 + 10,000) = $3.86.