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What is the Reverse Treasury Stock Method?

Reverse Treasury Stock Method

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Reverse Treasury Stock Method

The Reverse Treasury Stock Method is a technique used to compute the potential dilutive effects of stock options, warrants, and other securities on an existing shareholder’s equity position. This method is particularly relevant for companies that have in-the-money options and warrants (i.e., where the exercise price is below the current market price) outstanding.

Here’s a step-by-step breakdown of how the Reverse Treasury Stock Method works:

  1. Calculation of Proceeds: First, the total proceeds that would be received by the company upon the exercise of all in-the-money options and warrants are calculated. This is done by multiplying the number of options/warrants by their respective exercise prices.
  2. Determination of Shares Repurchased: Using the current market price of the company’s stock, the number of shares that could be theoretically repurchased with the total proceeds from step 1 is determined.
  3. Calculation of Net Additional Shares: The number of shares calculated in step 2 (the repurchased shares) is then subtracted from the total number of options and warrants to yield the net increase in shares outstanding due to the exercise of these options and warrants.
  4. Dilution Impact: Finally, the net additional shares from step 3 are added to the current number of shares outstanding to give the new total shares outstanding after considering the dilutive effect of the options and warrants.

It’s important to note that the Reverse Treasury Stock Method assumes that the proceeds from the exercise of options and warrants are used to repurchase shares in the market at the current price. This is the “reverse” aspect of the method: instead of issuing treasury stock (as in the traditional method), it’s like the company is buying back its own shares using the proceeds from the exercised options/warrants.

This method provides a conservative estimate of the dilutive impact of options and warrants on existing shareholders since it accounts for the possibility of repurchasing shares with the proceeds from these securities’ exercise.

Example of the Reverse Treasury Stock Method

Imagine a company, XYZ Corp, with the following details:

  • Current number of shares outstanding: 1,000,000 shares
  • Current stock price: $50 per share
  • Outstanding stock options: 100,000 options
  • Exercise price of the stock options: $40 per option

Step 1: Calculation of Proceeds:
If all the stock options are exercised, XYZ Corp would receive:
100,000 options × $40/option = $4,000,000

Step 2: Determination of Shares Repurchased:
With the $4,000,000, XYZ Corp could repurchase shares at the current market price. The number of shares they could buy back is:
$4,000,000 ÷ $50/share = 80,000 shares

Step 3: Calculation of Net Additional Shares:
Subtract the repurchased shares from the total options:
100,000 options – 80,000 shares = 20,000 net additional shares

Step 4: Dilution Impact:
Add the net additional shares to the current number of shares outstanding:
1,000,000 shares + 20,000 shares = 1,020,000 total shares outstanding after considering the dilutive effect

Conclusion:
After considering the dilutive impact of the options using the Reverse Treasury Stock Method, XYZ Corp would have a total of 1,020,000 shares outstanding.

Remember, this method provides a conservative estimate of the dilutive impact of options and assumes the company uses all the proceeds from the exercise of stock options to buy back shares at the current market price.

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