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                                                CHAPTER 11
                            LONG-TERM LIABILITIES: NOTES, BONDS, AND LEASES- 2008
E11–1
a. Melrose Enterprises' debt/equity ratio is currently 1.25 [($200,000 + $300,000) ÷ $400,000]. The company's
   loan agreement specifies that debt can be twice the stockholders' equity. Consequently, the company's debt
   cannot exceed $800,000. Since Melrose Enterprises already has $500,000 in debt, the company can borrow an
   additional $300,000.

b.   By definition, Melrose Enterprises will settle its December 31, 2008 current liabilities sometime during 2009.
     The company will probably also incur new current liabilities as of December 31, 2009. Since no information is
     provided as to the expected amount of current liabilities as of December 31, 2009, a reasonable assumption is
     that these liabilities will remain at $200,000. Consequently, Melrose Enterprises would have total debt of
     $500,000 and total stockholders' equity of $550,000 ($400,000 + $950,000 in revenues – $800,000 in
     expenses). The company could now borrow a total of $1,100,000 ($550,000  2) without violating the debt
     covenant. Melrose Enterprises could, therefore, borrow an additional $600,000.

c.   At the end of 2009, Melrose Enterprises would have $200,000 in current liabilities and $300,000 in long-term
     debt for total debt of $500,000, and it would have $450,000 in stockholders' equity ($400,000 + $950,000 in
     revenues – $800,000 in expenses – $100,000 in declared dividends). The company could now borrow a total of
     $900,000 (i.e., $450,000  2) without violating its debt covenant. Consequently, Melrose Enterprises could
     borrow an additional $400,000.

     If Melrose Enterprises declares, but does not pay, the $100,000 dividend, the company's debt/equity ratio will be
     affected. Dividends that are declared but not paid are typically classified as current liabilities. Consequently,
     Melrose Enterprises would have $300,000 in current liabilities and $300,000 in long-term liabilities for total
     liabilities of $600,000, and it would have $450,000 in stockholders' equity, which means that the company could
     borrow a total of $900,000 without violating its debt covenant. Consequently, Melrose Enterprises could borrow
     an additional $300,000. Declaring but not paying the dividend, as opposed to declaring and paying the dividend,
     reduced the amount of money that the company could borrow on a dollar-for-dollar basis.
E11–3
1       Par value
2       Discount
3       Premium
4       Premium
E11–5
a.            Present Value      = Present Value of Face Value + Present Value of Interest Payments
                    $11,348      = ($20,000  Present Value Factor for i = ? and n = 5) +
                                       [($20,000  0%)  Present value of an ordinary annuity factor
                                       for i = ? and n = 5]
                                 = ($20,000  Present Value Factor) + $0
     Present Value Factor        = 0.5674
     Looking in the n = 5 row of Table 4 in Appendix A reveals that a present value factor of 0.5674 corresponds to
     an annual effective interest rate of 12%.

b.   Equipment (+A) ...............................................................................................   11,348
     Discount on Notes Payable (–L) ......................................................................             8,652
         Notes Payable (+L) ...................................................................................                20,000
     Purchased equipment by issuing a note.

c.   Interest Expense                = Book Value of Debt  Effective Interest Rate
                                     = ($20,000 – $8,652)  12%
                                     = $1,361.76

d.   Balance Sheet Value                       =       Face Value of Note – Discount on Notes Payable
                                               =       $20,000.00 – ($8,652.00 – $1,361.76)
                                               =       $12,709.76
                                                                                 1
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e.   Interest expense is computed as the debt's book value times the effective interest rate. For a note issued at a
     discount, the book value will increase over time until the book value equals the face value immediately prior to
     the note maturing. Since the book value is greater at the beginning of Year 2 than it was at the beginning of Year
     1, and the effective interest rate is constant, the interest expense recognized by Tradewell in the second year will
     be greater than the interest expense recognized in the first year.

     Intuitively this makes sense. During Year 1, Tradewell only "borrowed" $11,348. Although Tradewell has to
     compensate the creditor for using the creditor's money during Year 1, Tradewell did not make any such payment
     to the creditor during Year 1 because the stated rate on the note is 0%. Thus, the amount that Tradewell should
     have compensated the creditor (i.e., interest expense) is simply added on to what Tradewell "borrowed" from the
     creditor. During Year 2, therefore, Tradewell has to pay interest not only on the initial $11,348 it "borrowed,"
     but also on the interest that it incurred, but did not pay, during Year 1.

     As proof, Interest Expense for Year 2                                 = $12,709.76 [from part (d)]  12%
                                                                           = $1,525.17

     This amount exceeds the interest expense for Year 1 computed in part (c).
f.   Since the note has not yet matured, the same logic used in part (e) can be applied to this question. Consequently,
     the interest expense recognized by Tradewell in the third year will be greater than the interest expense
     recognized in the second year.

     As proof, Interest Expense for Year 3                              = Book Value at Beginning of Year 3  12%
                                                                        = [$20,000.00 – ($8,652.00 – $1,361.76 –
                                                                        $1,525.17)]  12%
                                                                        = $1,708.19
   This amount exceeds the interest expense for Year 2 computed in part (e).
E11–13
a. Face value .............................................................................................           $                 500,000
   Present value (i = 4%, n = 10)
   PV of face value
      ($500,000  0.6756 from Table 4 in Appendix A) ..........................                             $ 337,800
   PV of interest payments
      ($15,000  8.1109 from Table 5 in Appendix A) ............................                              121,664
   Total present value ...............................................................................                                  459,464
   Discount................................................................................................           $                  40,536

     Cash (+A) .....................................................................................................   459,464
     Discount on Bonds Payable (–L) ..................................................................                  40,536
         Bonds Payable (+L) ...............................................................................                          500,000
     Issued bonds.

b.   Interest Expense (E, –SE) .............................................................................            18,378.56a
          Discount on Bonds Payable (+L)...........................................................                                    3,378.56c
          Interest Payable (+L) .............................................................................                         15,000.00b
     Accrued interest payable.

     a $18,378.56 = Book Value  Effective Rate per Period = $459,464  4%
     b $15,000.00 = Face Value  Stated Rate per Period = $500,000  3%
     c $3,378.56 = $18,378.56 – $15,000.00

c.   Balance sheet value as of 12/31/09                                  =       Face value – Discount as of 12/31/09
                                                                         =       $500,000.00 – ($40,536.00 – $3,378.56)
                                                                         =       $462,842.56
d.   Present value (i = 4%, n = 9)
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     PV of face value
        ($500,000  0.7026 from Table 4 in Appendix A) ..................................                                  $   351,300.00
     PV of interest payments
        ($15,000  7.4353 from Table 5 in Appendix A) ....................................                                     111,530.00
     Total present value .......................................................................................           $   462,830.00

   Notice that the $462,842.56 from part [c] is essentially identical to the $462,830.00 just calculated. Amortizing
   discounts and premiums using the effective interest rate results in bonds being carried on the balance sheet at an
   amount equal to the present value of the bonds, using the effective interest rate on the date the bonds were issued
   as the discount rate.
E11–22
a. Lease Expense (E, –SE)...................................................................................        10,000
        Cash (–A) .................................................................................................        10,000
   Incurred and paid lease expense for 2008.

     Lease Expense (E, –SE)...................................................................................                 10,000
         Cash (–A) .................................................................................................                        10,000
     Incurred and paid lease expense for 2009.

     Lease Expense (E, –SE)...................................................................................                 10,000
         Cash (–A) .................................................................................................                        10,000
     Incurred and paid lease expense for 2010.

     Lease Expense (E, –SE)...................................................................................                 10,000
         Cash (–A) .................................................................................................                        10,000
     Incurred and paid lease expense for 2011.

     Lease Expense (E, –SE)...................................................................................                 10,000
         Cash (–A) .................................................................................................                        10,000
     Incurred and paid lease expense for 2012.

b.   The effective interest rate on the lease is 8%. The following entries would be recorded on Q-Mart’s books.

     Facility (A) ......................................................................................................       39,927
         Lease Liability (L) ....................................................................................                           39,927
     Record the capitalized lease. ($10,000*3.9927)

     Depreciation Expense (E, –SE) .......................................................................                      7,985.40
         Accumulated Depreciation (–A) ...............................................................                                       7,985.40
     Record depreciation of capitalized asset for 2008. ($39,927/5)

     Lease Liability (-L) ..........................................................................................            6,805.84
     Interest Expense (E, -SE).................................................................................                 3,194.16
          Cash (-A) ..................................................................................................                      10,000
     Made lease payment for 2008.


     Depreciation Expense (E, –SE) .......................................................................                      7,985.40
         Accumulated Depreciation (–A) ...............................................................                                       7,985.40
     Record depreciation of capitalized asset for 2009.

     Lease Liability (-L) ..........................................................................................            7,350.32
     Interest Expense (E, -SE).................................................................................                 2,649.68
          Cash (-A) ..................................................................................................                      10,000
     Made lease payment for 2009.
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     Depreciation Expense (E, –SE) .......................................................................               7,985.40
         Accumulated Depreciation (–A) ...............................................................                               7,985.40
     Record depreciation of capitalized asset for 2010.

     Lease Liability (-L) ..........................................................................................     7,938.32
         Interest Expense (E, -SE) .........................................................................             2,061.68
         Cash (-A) ..................................................................................................               10,000
     Made lease payment for 2010.

     Depreciation Expense (E, –SE) .......................................................................               7,985.40
         Accumulated Depreciation (–A) ...............................................................                               7,985.40
     Record depreciation of capitalized asset for 2011.

     Lease Liability (-L) ..........................................................................................     8,573.36
     Interest Expense (E, -SE).................................................................................          1,426.64
          Cash (-A) ..................................................................................................              10,000
     Made lease payment for 2011.

     Depreciation Expense (E, –SE) .......................................................................               7,985.40
         Accumulated Depreciation (–A) ...............................................................                               7,985.40
     Record depreciation of capitalized asset for 2012.

     Lease Liability (-L) ..........................................................................................     9,260.00
     Interest Expense (E, -SE).................................................................................            740.00
          Cash (-A) ..................................................................................................              10,000
     Made lease payment for 2012.

c.   Classifying the lease as an operating lease would give rise to both higher net income and a lower debt/equity
     ratio. By classifying the lease as an operating lease, net income would be reduced during 2008 by $10,000 [from
     part (a)] for rent expense. Alternatively, classifying the lease as a capital lease would reduce net income by a
     total of $11,179.56 [from part (b)] for the interest expense associated with the lease and for the depreciation
     associated with the capitalized asset.
     Future obligations under operating leases are not disclosed in a company's financial statements as a liability.
     Consequently, an operating lease would not affect a company's total liabilities. On the other hand, the present
     values of future lease obligations are reported as liabilities under capital leases, which means that a capital lease
     results in increased liabilities compared to an operating lease. In addition, the differential effect of capital and
     operating leases on net income will affect total stockholders' equity through Retained Earnings.

     Specifically, the balance in Retained Earnings, and thus total stockholders' equity, will be higher by classifying
     the lease as an operating lease as opposed to classifying it as a capital lease. Therefore, Q-Mart’s total liabilities
     would be lower and its stockholders' equity higher if the lease were classified as an operating lease rather than as
     a capital lease. This means that classifying the lease as an operating lease would yield a lower debt/equity ratio.
     At the end of the useful life both will be equal.

				
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