The Treasury Stock Method, Explained

Options are in-the-money ($50 > $40). Under the treasury stock method: Net new shares from options = 20m − (20m × $40 / $50) = 20m − 16m = 4 million shares. Warrants are out-of-the-money because the strike ($55) exceeds the current price ($50). They are antidilutive and excluded from diluted shares. Convertible bonds: the conversion price is $50, equal to the share price. At the money, I would include the conversion shares under the if-converted method, assuming conversion occurs, so add 6 million shares. Total diluted shares = 200m basic + 4m option dilution + 6m convert dilution = 210 million shares.

If asked to be precise, I would note that the TSM only applies to options/warrants; for converts, we use the if-converted method, adding back the after-tax interest saved. However, when the conversion price equals current price, the dilutive effect is simply the conversion shares.

Follow-up pressure:

• How would your answer change if the convertible had a cash settlement feature and the company’s credit spread widened? Would you still use the if-converted method?
• If the warrants had a $1 exercise price and represented 30% of the current share base, would you still apply the TSM blindly? What alternative method might be more appropriate?
• Explain why we ignore out-of-the-money instruments under current GAAP and when that assumption becomes misleading.