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CHAPTER 11 LONG-TERM LIABILITIES: NOTES, BONDS, AND LEASES BRIEF EXERCISES BE11–1 a. During 2003 Radio Shack paid down $20 million of the medium-term notes. At the same time during 2003 Radio Shack incurred a small amount of capital lease obligations. The balance sheet and the statement of cash flows were affected by these transactions. b. During 2003 approximately $10.425 million of interest expense was recognized on the 6.95% notes (6.95% x $150 million). c. If Radio Shack paid $30 million to retire the medium term notes in 2003 the company would have recorded a gain of $14.5 million on the transaction. ($44.5 – $30). This would be found on the income statement as a gain on the early extinguishment of debt. BE11–2 a. The life of these bonds is 20 years, from 1997 until 2017. b. The stated interest rate is 0%. c. The effective rate is 3.2%. (The present value is $968 million, while the future value of the single sum in 20 years is $1.8 billion.) d. Bonds typically are issued in amounts of $1,000, therefore Hewlett-Packard issued 1.8 million bonds with a total face value of $1.8 billion. BE11–3 a. The operating lease payments reduced the reported income for the period, reduced the assets on the balance sheet (payment of cash), and impacted the statement of cash flows by reducing the net income of SuperValu for the reporting period. By reducing net income these lease payments are a use of cash from operations. b. The interest portion of capital lease payments and the depreciation on the capitalized lease assets reduce reported net income statement for the period. They also impact the balance sheet by reducing both the assets and the liabilities on the balance sheet. For a capital lease the interest payments is cash from operations, principal reductions is financing and the depreciation has no impact on the statement of cash flows. c. The $120 million of operating leases is a form of off-balance sheet financing for SuperValu. Supervalu does not have to show these future liabilities on its balance sheet. These future contractual payments are disclosed in the footnotes. One of the advantages of this approach is that these liabilities are not used in the calculation of liquidity ratios. 1 EXERCISES 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, 2005 current liabilities sometime during 2006. The company will probably also incur new current liabilities as of December 31, 2006. Since no information is provided as to the expected amount of current liabilities as of December 31, 2006, 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 2006, 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. E11–2 a. 1/1/05 1/1/06 1/1/07 1/1/08 1/1/09 1/1/10 $30,000 $30,000 $30,000 $30,000 $30,000 $300,000 b. All dollar amounts on the time line below are in thousands of dollars. 1/05 7/05 1/06 7/06 1/07 7/07 1/08 7/08 1/09 7/09 1/10 $15 $15 $15 $15 $15 $15 $15 $15 $15 $15 $300 c. Total Present Value = Present Value of Face Value + Present Value of Periodic Interest Payments (1) Annual interest payments: Total Present Value = ($300,000 Present Value Factor for i = 10% and n = 5) + ($30,000 Present Value Factor of an Ordinary Annuity Factor for i = 10% and n = 5) = ($300,000 .62092 from Table 4, Appendix B) + ($30,000 3.79079 from Table 5, Appendix B) = $186,276 + $113,724 = $300,000 (2) Semiannual interest payments: Total Present Value = ($300,000 Present Value Factor for i = 5% and n = 10) + ($15,000 Present Value Factor of an Ordinary Annuity Factor for i = 5% and n = 10) = ($300,000 .61391 from Table 4, Appendix B) + ($15,000 7.7218 from Table 5, Appendix B) = $184,173 + $115,827 = $300,000 E11–3 1 Par value 2 Discount 3 Premium 4 Premium E11–4 Present Value = Present Value of Face Value + Present Value of Interest Payments Note 1 Present Value = ($1,000 Present Value Factor for i = 8% and n = 4) + [($1,000 0%) Present Value of an Ordinary Annuity Factor for i = 8% and n = 4] = $1,000 .7350 (from Table 4 in Appendix B) + $0 = $735.00 Note 2 Present Value = ($5,000 Present Value Factor for i = 6% and n = 6) + [($5,000 0%) Present Value of an Ordinary Annuity Factor for i = 6% and n = 6] = $5,000 .7050 (from Table 4 in Appendix B) + $0 = $3,525.00 Note 3 Present Value = ($8,000 Present Value Factor for i = 12% and n = 6) + [($8,000 4%) Present Value of an Ordinary Annuity Factor for i = 12% and n = 6] = ($8,000 .5066 (from Table 4 in Appendix B) + ($320 4.1114 (from Table 5 in Appendix B) = $4,052.80 + $1,315.65 = $5,368.45 Note 4 Present Value = ($3,000 Present Value Factor for i = 8 % and n = 7) + [($3,000 8%) Present Value of an Ordinary Annuity Factor for i = 8% and n = 7] = ($3,000 .5835 (from Table 4 in Appendix B) + ($240 5.2064) (from Table 5 in Appendix B) = $1,750.50 + $1,249.54 = $3,000.00 Note 5 Present Value = ($10,000 Present Value Factor for i = 6 % and n = 10) + [($10,000 10%) Present Value of an Ordinary Annuity Factor for i = 6% and n = 10] = ($10,000 .5584 (from Table 4 in Appendix B) + ($1,000 7.3601 (from Table 5 in Appendix B) = $5,584.00 + $7,361.00 = $12,945.00 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 B 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 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). E11–5 Concluded 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). E11–6 a. Stated interest rate = 8% Cash (+A) ......................................................................................... 8,000 Notes Payable (+L) .................................................................... 8,000 Issued notes payable. Interest Expense (E, –SE) ............................................................... 640 Cash (–A) ................................................................................... 640 Incurred and paid interest. Interest Expense (E, –SE) ............................................................... 640 Cash (–A) ................................................................................... 640 Incurred and paid interest. Notes Payable (–L) .......................................................................... 8,000 Cash (–A) ................................................................................... 8,000 Repaid notes payable. b. Stated interest rate = 0% Face value ............................................................................. $ 8,000.00 Present value (i = 8%, n = 2) Present value of face value $8,000 .8573 (from Table 4 in Appendix B) ................ 6,858.40 Discount on notes payable.................................................... $ 1,141.60 Cash (+A) ......................................................................................... 6,858.40 Discount on Notes Payable (–L) ...................................................... 1,141.60 Notes Payable (+L) .................................................................... 8,000.00 Issued notes payable. Interest Expense (E, –SE) ............................................................... 548.67 Discount on Notes Payable (+L) ................................................ 548.67 Incurred interest. Interest Expense (E, –SE) ............................................................... 592.93 Discount on Notes Payable (+L) ................................................ 592.93 Incurred interest. E11–6 Concluded Notes Payable (–L) .......................................................................... 8,000.00 Cash (–A) ................................................................................... 8,000.00 Repaid notes payable. c. Stated interest rate = 6% Face value ........................................................................................ $8,000.00 Present value (i = 8%, n = 2) Present value of face value $8,000 .8573 (from Table 4 in Appendix B) .......................... $6,858.40 Present value of interest payments ($8,000 6%) 1.7833 (from Table 5 in Appendix B) ............ 855.98 Total present value ........................................................................... 7,714.38 Discount on notes payable............................................................... $ 285.62 Cash (+A) ......................................................................................... 7,714.38 Discount on Notes Payable (–L) ...................................................... 285.62 Notes Payable (+L) .................................................................... 8,000.00 Issued notes payable. Interest Expense (E, –SE) ............................................................... 617.15a Discount on Notes Payable (+L) ................................................ 137.15b Cash (–A) ................................................................................... 480.00c Incurred and paid interest. a $617.15 = Book Value Effective Interest Rate = 7,714.38 8% b $137.15 = Interest Expense – Interest Payment c $480.00 = Face Value Stated Interest Rate = $8,000 6% Interest expense (E, –SE) ................................................................ 628.47a Discount on Notes Payable (+L) ................................................ 148.47b Cash (–A) ................................................................................... 480.00 Incurred and paid interest. a $628.47 = Book Value Effective Interest Rate = (7,714.38 + 137.15) 8% b $148.47 = $8,000.00 – [$7,714.38 + $137.15 (from prior entry)] Notes Payable (–L) .......................................................................... 8,000 Cash (–A) ................................................................................... 8,000 Repaid notes payable. E11–7 a. Present value = Present value of face value + Present value of periodic interest payments (1) Discount rate = 8% Present value of face value (i = 8%, n = 2) ($2,500 0.85734 from Table 4 in Appendix B) $ 2,143.35 Present value of periodic interest payments (i = 8%, n = 2) ($200 1.78326 from Table 5 in Appendix B) 356.65 Total present value $ 2,500.00 (2) Discount rate = 10% Present value of face value (i = 10%, n = 2) ($2,500 0.82645 from Table 4 in Appendix B) $ 2,066.13 Present value of periodic interest payments (i = 10%, n = 2) ($200 1.73554 from Table 5 in Appendix B) 347.11 Total present value $ 2,413.24 (3) Discount rate = 12% Present value of face value (i = 12%, n = 2) ($2,500 0.79719 from Table 4 in Appendix B) $ 1,992.98 Present value of periodic interest payments (i = 12%, n = 2) ($200 1.69005 from Table 5 in Appendix B) 338.01 Total present value $ 2,330.99 b. The effective interest rate is the interest rate that equates the undiscounted future cash flows with the present value of the future cash flows. In this case, the undiscounted future cash flows are (1) the $2,500 face value due in two years and (2) the interest payments of $200 due at the end of each year for two years, while the present value of the note is the proceeds of $2,413. From part (a), a discount rate of 10% equates the future cash flows and the proceeds. Therefore, the effective interest rate is 10%. c. If Wilmes Floral Supplies originally borrowed $2,500, the $2,500 would be the present value of the future cash flows. From part (a), a discount rate of 8% equates the future cash flows with $2,500. The effective interest rate would, therefore, be 8%. Anytime the proceeds equal the face value, the effective interest rate equals the stated interest rate. E11–8 a. The building should be capitalized at the cash value of the transaction. In this particular case, the cash value of the transaction would be assumed to equal the building's appraised value. Therefore, the building should be recorded at $550,125. E11–8 Concluded b. The total present value of a note equals the sum of the present value of the note's face value and the present value of the periodic interest payments specified in the note. Since the note signed by Morrow Enterprises is non-interest-bearing, there are no periodic interest payments, and the present value of the note would equal just the present value of the note's face value. (1) Discount Rate = 6% Present Value = ($693,000 Present Value Factor for i = 6% and n = 3) = $693,000 0.83962 from Table 4 in Appendix B) = $581,856.66 (2) Discount Rate = 8% Present Value = ($693,000 Present value factor for i = 8% and n = 3) = $693,000 0.79383 from Table 4 in Appendix B) = $550,124.19 (3) Discount Rate = 10% Present Value = ($693,000 Present value factor for i = 10% and n = 3) = $693,000 0.75131 from Table 4 in Appendix B) = $520,657.83 c. The effective interest rate is the rate that equates the undiscounted future cash flows with the present value of the future cash flows. In this case, the undiscounted future cash flow is the $693,000 face value due in three years, and the present value of the note is the value of the building, or $550,125. From part (b), a discount rate of 8% equates the future cash flows and the proceeds. Therefore, the effective interest rate is 8%. d. Since the note is non-interest-bearing, the only cash flow is the face value of $693,000. Dividing the present value of $550,125 by the face value of $693,000 yields a present value factor of .79383. Looking across the n = 3 row of the present value of $1 table (i.e., Table 4) in Appendix B reveals that the annual effective interest rate on this note is 8%. E11–9 a. Interest Expense = Effective Rate Book Value of Debt at Beginning of the Period $16,400 = Effective Rate ($200,000 – $14,400) Effective Interest Rate = 8.8% (rounded) b. Interest Expense (E, –SE) ............................................................... 16,400 Discount on Notes Payable (+L) ................................................ 2,400* Cash (–A) ................................................................................... 14,000 Incurred and paid interest. * $2,400 = Change in the balance of Discount on Notes Payable E11–10 a. The ten-year notes call for annual interest of $20.025 million (stated rate of 6.5% X face value of $385 million) and the repayment of $385 million in principal. The proceeds of the notes were $380 million. If the present value of the contract is $380 million and the future values are represented in the interest (ordinary annuity) and the principal (single sum), then the effective interest rate is the rate that discounts the future values to the present value of $380 million. The effective interest rate is approximately 6.7%. (The general present value formula of 1/[(1 + r) to the nth] was used in this calculation.) b. The interest expense for 2002 will be the effective rate of 6.7% multiplied by the proceeds of $380 million, or $25.46 million. This amount is made up of $25.025 million of cash paid plus $.435 million of non-cash interest from the amortization of the bond discount. c. The market paid less than $385 million for these bonds because the market demands 6.7% interest for their investment dollars for the risk posed by the company at the time of issuance. The notes only pay a cash interest rate of 6.5% and so the only way that investors can make their desired return is to pay less for the notes. This allows the investors to make the market rate of 6.7%. E11–11 a. Bond A Face value ................................................................................. $ 100,000 Present value (i = 3%, n = 20) PV of face value ($100,000 0.55368 from Table 4 in Appendix B) .............. $ 55,368 PV of periodic interest payments ($3,000 x 14.87747 from Table 5 in Appendix B) ................ 44,632 Total present value (i.e., proceeds) .......................................... 100,000 Discount/premium ..................................................................... $ 0 Bond B Face value ................................................................................. $ 400,000 Present value (i = 3%, n = 20) PV of face value ($400,000 0.55368 from Table 4 in Appendix B) .............. $ 221,472 PV of periodic interest payments ($16,000 14.87747 from Table 5 in Appendix B) .............. 238,040 Total present value (i.e., proceeds) .......................................... 459,512 Premium .................................................................................... $ 59,512 Bond C Face value ................................................................................. $ 600,000 Present value (i = 4%, n = 10) PV of face value ($600,000 0.67556 from Table 4 in Appendix B) .............. $ 405,336 PV of periodic interest payments ($18,000 8.11090 from Table 5 in Appendix B) ................ 145,996 Total present value (i.e., proceeds) .......................................... 551,332 Discount .................................................................................... $ 48,668 E11–11 Concluded b. Immediately before a bond matures, its carrying value on the balance sheet must equal its face value. Thus, discounts and premiums must be amortized over time so that the carrying value approaches the bond's face value over time. For bonds that are issued at their face value, such as Bond A, the bond is already stated at its face value and there is no discount or premium to amortize. Consequently, the carrying value of the bond will remain equal to its face value over the life of the bond. Thus, the carrying value of Bond A will remain constant over its life. For bonds issued at a discount, such as Bond C, the carrying value on the date the bond is issued is less than its face value. Consequently, over the life of the bond, its carrying value must increase as the discount is amortized. Remember that a discount on a bond is deducted from the bond's face value to determine the carrying value. Thus, any reduction in the discount balance, such as when the discount is being amortized, will decrease the amount being deducted from the face value, which thereby increases the carrying value of the bond. The carrying value of Bond C will, therefore, increase over its life. Alternatively, the carrying value of Bond B will decrease over its life. For bonds issued at a premium, such as Bond B, the carrying value on the date the bond is issued is greater than its face value. Consequently, over the life of the bond, its carrying value must decrease as the premium is amortized. Remember that a premium on a bond is added to the bond's face value to determine the carrying value. Thus, any reduction in the premium balance, such as when the premium is being amortized, will decrease the amount being added to the face value, which thereby decreases the carrying value of the bond. Thus, the carrying value of Bond B will decrease over its life. c. Interest expense is computed as the bond's book value at the beginning of the accounting period times the effective interest rate per period. Since accountants use the effective interest rate on the date a bond is issued to calculate interest expense, the effective interest rate is constant over the bond's life. This implies that the only factor that could affect whether the interest expense recognized each period increases, decreases, or remains constant over the life of the bond is the book value. As discussed in part (b), the book value of Bond A will remain constant over the life of the bond issue. Consequently, the interest expense recognized in each accounting period will remain constant over the life of Bond A. Alternatively, the interest expense recognized for Bonds B and C will vary across periods. Since the book value of Bond B will decrease over the life of the bond issue [see part (b)], interest expense associated with Bond B will also decrease from one period to the next. The interest expense associated with Bond C will increase from one period to the next because the book value of Bond C will increase each period [see part (b)]. E11–12 a. 1/1/05 Cash (+A) ................................................................... 30,000 Bonds Payable (+L) ............................................. 30,000 Issued bonds for cash. b. 6/30/05 Interest Expense (E, –SE).......................................... 1,500a Cash (–A) ............................................................. 1,500b Incurred and paid interest. a $1,500 = Book Value Effective Interest Rate per Period = $30,000 5%P b $1,500 = Face Value Stated Interest Rate per Period = $30,000 5% 12/31/05 Interest Expense (E, –SE).......................................... 1,500 Cash (–A) ............................................................. 1,500 Incurred and paid interest. c. Balance Sheet Value = Face Value – Associated Discount + Associated Premium = $30,000 – $0 + $0 = $30,000 d. Present value (i = 5%, n = 18) PV of face value ($30,000 .4155) ........................................................................ $12,465 PV of interest payments ($1,500 11.6896) ...................................................................... 17,534 Total present value ........................................................................... $30,000 e. Balance Sheet Value as of 12/31/06 = Face Value – Associated Discount + Associated Premium = $30,000 – $0 + $0 = $30,000 Present value as of 12/31/06 (i = 5%, n = 16) PV of face value ($30,000 .4581) ........................................................................ $13,743 PV of interest payments ($1,500 10.8378) ...................................................................... 16,257 Total present value ........................................................................... $30,000 Notice that the balance sheet value of $30,000 is identical to the present value just calculated. Amortizing premiums and discounts using the effective interest rate results in bonds being carried on the balance sheet at an amount equal to the present value of the future cash flows of the bonds, using the effective interest rate on the date the bonds were issued as the discount rate. 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 B) ............. $ 337,800 PV of interest payments ($15,000 8.1109 from Table 5 in Appendix B) ............... 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 12/31/06 = Face value – Discount as of 12/31/06 = $500,000.00 – ($40,536.00 – $3,378.56) = $462,842.56 d. Present value (i = 4%, n = 9) PV of face value ($500,000 0.7026 from Table 4 in Appendix B) .................... $ 351,300.00 PV of interest payments ($15,000 7.4353 from Table 5 in Appendix B) ...................... 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. E11–14 a. Face value .............................................................................. $ 100,000 Present value (i = 3%, n = 20) PV of face value ($100,000 0.55368 from Table 4 in Appendix B) ........... $ 55,368 PV of interest payments ($4,000 14.87747 from Table 5 in Appendix B) ............. 59,510 Total present value ................................................................. 114,878 Premium ................................................................................. $ 14,878 E11–14 Concluded Cash (+A) ...................................................................................... 114,878 Premium on Bonds Payable (+L) ........................................... 14,878 Bonds Payable (+L) ................................................................ 100,000 Issued bonds. b. Interest Expense (E, –SE) ............................................................ 3,446.34a Premium on Bonds Payable (-L)................................................... 553.66c Interest Payable (+L)............................................................... 4,000.00b Accrued interest payable. a $3,446.34 = Book Value Effective Rate per Period = $114,878 3% b $4,000.00 = Face Value Stated Rate per Period = $100,000 4% c $553.66 = $4,000.00 – $3,446.34 c. Balance sheet value as of 12/31/06 = Face value + Premium as of 12/31/06 = $100,000.00 – ($14,878.00 – $553.66) = $114,324.34 d. Present value (i = 3%, n = 19) PV of face value ($100,000 0.57029 from Table 4 in Appendix B) .................. $ 57,029.00 PV of interest payments ($4,000 14.3238 from Table 5 in Appendix B) ...................... 57,295.20 Total present value ........................................................................ $ 114,324.20 Notice that the $114,324.34 from part [c] is essentially identical to the $114,324.20 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. E11–15 a. Since it is one year later, two interest periods have passed. Thus, there are only eight remaining interest periods. Present value (i = 3%, n = 8) PV of face value ($20,000 0.7894 from Table 4 in Appendix B) ..................... $15,788.00 PV of interest payments ($800 7.0197 from Table 5 in Appendix B) .......................... 5,615.76 Total present value ....................................................................... $21,403.76 To determine whether Treadway has experienced an economic gain or loss, we need to know both the market value and the carrying value of the bonds. The market value of the bonds on December 31, 2005 should equal the present value of the bond's future cash flows discounted using the prevailing market interest rate. Thus, the market value of Treadway's bonds on December 31, 2005 is $21,403.76. Since the bonds were issued at face value, the effective interest rate on the date of issue equaled the stated interest rate, and there was no discount or premium associated with the bonds. When bonds are issued at face value, the bonds are carried on the books at face value until the bonds mature. Consequently, the book value of these bonds is $20,000.00. Since the market value of the bonds now exceeds $20,000.00, Treadway has experienced an economic loss. That is, if Treadway wanted to retire the bonds, it E11–15 Concluded would cost the company $21,403.76 rather than $20,000.00. The amount of the loss is the excess of the bond's market value over the bond's book value, or $1,403.76. b. Present value (i = 5%, n = 8) PV of face value ($20,000 0.6768 from Table 4 in Appendix B) ......................... $13,536.00 PV of interest payments ($800 6.4632 from Table 5 in Appendix B) .............................. 5,170.56 Total present value ........................................................................... $18,706.56 The market value of the bonds is now less than their book value. If Treadway Company wanted to retire the bonds through the bond market, it would have to pay less than the value of the bonds per the company's financial records. Therefore, the effective liability of the company has decreased, which implies that the company has experienced an economic gain. The gain would be the excess of the bonds' book value over the bonds' market value, or $1,293.44. c. Companies experience economic gains and losses when their wealth changes. In the case of bonds, their market value indicates the company's effective obligation on the bonds at that particular point in time. If the market value exceeds the bonds' book value, then the company has experienced a decrease in wealth; if the market value is less than book value, then the company has experienced an increase in wealth. Such gains and losses, however, are not usually reflected in a company's financial statements because it is assumed that when a company issues bonds, the bonds will remain outstanding until they mature. That is, the company will not retire the bonds before they mature. On the date that the company issued the bonds, the company locked into the market rate of interest on that day. This means that the effective interest rate on the date the bonds are issued is the interest rate the company expects to incur over the life of the bonds. Thus, the economic gains and losses due to fluctuations in the market interest rate will essentially "wash out" over the life of the bonds because the bonds are expected to remain outstanding until they mature. Economic gains or losses associated with changes in the market interest rate are only reflected in a company's financial statements when a company retires some bonds prior to their maturity date. If you were analyzing Treadway's financial statements, you might want to adjust the amounts reported for notes and bonds to reflect the prevailing market interest rate. In this manner, the statements would more accurately reflect the company's economic liability—and hence associated gains and losses—compared to the amounts reported on the balance sheet. E11–16 a. Cash paid to redeem the bonds = Face value 101% = $500,000 101% = $505,000 Bonds Payable (–L).......................................................................... 500,000 Loss on Redemption (Lo, –SE) ........................................................ 15,000 Discount on Bonds Payable (+L) ............................................... 10,000* Cash (-A) .................................................................................... 505,000 Redeemed bonds. * $10,000 = Face Value – Book Value = $500,000 – $490,000 b. Bonds Payable (–L).......................................................................... 500,000 Premium on Bonds Payable (–L) ..................................................... 7,000 Cash (–A) ................................................................................... 505,000 Gain on Redemption (Ga, +SE)................................................. 2,000 Redeemed bonds. E11–17 a. Lilly paid $47 million to retire this debt. This is comprised of $35 million (book value of bonds), $7.2 million (after tax loss) plus $4.8 million (tax benefit of loss). b. The $4.8 million is a benefit to the company because the loss offsets against the operating income of Lilly. As a result it reduces the amount of tax that Lilly will have to pay. Therefore the loss on retiring this debt provides a tax benefit to Lilly. c. The loss would be shown as part of the net income that is shown on the first line item on the statement of cash flows. It would be added back to compute cash from operating activities. d. The loss would be shown as an extraordinary item on the income statement. E11–18 a. American Greetings paid cash of $181.2 million to retire the debt (book value of $142.2 million plus loss on debt repurchase of $39.0 million). b. The company, in effect, paid extra to make the debt go away. The debt was on the books for $142.2 million, but the company—through negotiations with the holders of the debt—agreed to pay a total of $181.2 million to retire the obligations. The additional amount paid, above the book value of the debt, is the amount of the loss recorded on the income statement. c. American Greetings refinanced the debt at much lower interest rates. A company would be willing to incur a loss on its income statement if it can refinance debt at much lower rates. Over the life of the new debt the company figures it will more than make up for the amount booked on the income statement as a loss by lowering its interest expense in all the years that the debt is outstanding. E11–19 a. Interest Expense (E, –SE) ............................................................... 4,822.70a Cash (–A) ................................................................................... 4,000.00b Discount on Bonds (+L) ............................................................. 822.70 Incurred and paid interest. a $4,822.70 = Book Value Effective Interest Rate per Period = $96,454 5% b $4,000.00 = Face Value Stated Interest Rate per Period = $100,000 4% b. Bonds Payable (–L).......................................................................... 100,000.00 Cash (–A) ................................................................................... 91,700.00 Discount on Bonds Payable (+L) ............................................... 2,723.30* Gain on Retirement of Bonds Payable (Ga, +SE) ..................... 5,576.70 Retired bonds. * $2,723.30 = $3,546 Discount balance as of 12/31/05 – $822.70 Discount amortized from 1/1/06 to 7/1/06 [from part (a)] E11–20 a. The effective interest rate can be calculated in two ways. The first way is by solving for i in the following equation where n=2 since there are two periods until maturity (12/31/05, the balance sheet date and maturity at 12/31/07). $94,650 = [($100,000 (1 + i )-2] + {$5,000 [(1 – [(1 + i)-2 + i ]} The second way is by trial and error. Simply plug an interest rate into the equation above until the right-hand side of the equation equals the left hand side. Since the bond is issued at a discount, we start with the knowledge that the effective rate is greater than the stated rate of 5%. The annual effective interest rate for the bonds is 8%. b. To the determine the effective rate an investor would be earning if the bonds were purchased on 12/31/05 at the market value of $98,167, perform the same procedure using the equation. $98,167 = [($200,000 (1 + i )-2] + {$10,000 [(1 – [(1 + i)-2 + i ]} The annual effective interest rate for the bonds is 6%. c. The book value of the bonds on Beasley Brothers’ books at December 31, 2005, is $94,650. The market value of the bonds as of December 31, 2005, is $98,167. The difference represents a loss of $3,517. It is a loss because if Beasley Brothers were to repurchase these bonds on the market in order to retire them, it would have to pay $3,517 more than the book value. Net income $27,000 Unrealized holding loss on Bonds Payable (3,517) Adjusted net income $23,483 The loss is not a decrease in the wealth of the company if it intends to keep the bonds outstanding until maturity. However, if Beasley intends to retire this debt, the loss represents a decrease in wealth because Beasley will sacrifice net assets of $3,517 to do so. d. Extraordinary Realized Loss on Retirement of Debt ................... 3,517 Bonds Payable ............................................................................. 100,000 Discount on Bonds Payable .................................................. 5,350 Cash ....................................................................................... 98,167 Once the repurchase has occurred, the loss has been realized because a reduction in net assets has occurred. Before this occurs, however, the loss is unrealized and may be misleading if the company intends to keep the bonds until maturity. E11–21 a. The effective interest rate can be calculated in two ways. The first way is by solving for i in the following equation where n=2 since there are two periods until maturity (12/31/06, the balance sheet date and maturity at 12/31/08). $193,059 = [($200,000 (1 + i )-2] + {$10,000 [(1 – [(1 + i)-2 + i ]} The second way is by trial and error. Simply plug an interest rate into the equation above until the right-hand side of the equation equals the left hand side. Since the bond is issued at a discount, we start with the knowledge that the effective rate is greater than the stated rate of 5%. The annual effective interest rate for the bonds is 6.92%. b. To the determine the effective rate an investor would be earning if the bonds were purchased on 12/31/06 at the market value of $186,479, perform the same procedure using the equation. $186,479 = [($100,000 (1 + i )-2] + {$5,000 [(1 – [(1 + i)-2 + i ]} The annual effective interest rate for the bonds is 8.83%. c. The book value of the bonds on Cohort Enterprises’ books at December 31, 2006 is $193,059. The market value of the bonds as of December 31, 2006 is $186,479. The difference represents a gain of $6,580. It is a gain because if Cohort Enterprises were to repurchase these bonds on the market in order to retire them, it would have to pay $6,580 less than the book value. Net income $38,500 Unrealized holding gain on Bonds Payable 6,580 Adjusted net income $45,080 The gain is not an increase in the wealth of the company if it intends to keep the bonds outstanding until maturity. However, if Cohort intends to retire this debt, the gain represents an increase in wealth because Cohort will acquire additional net assets of $6,580. d. Bonds payable................................................................................. 200,000 Discount on Bonds Payable ...................................................... 6,941 Cash ........................................................................................... 186,479 Extraordinary Realized Gain on Retirement of Debt ................. 6,580 Once the repurchase has occurred, the loss has been realized because a reduction in net assets has occurred. Before this occurs, however, the loss is unrealized and may be misleading if the company intends to keep the bonds until maturity. E11–22 a. Lease Expense (E, –SE) .................................................................. 10,000 Cash (–A) ................................................................................... 10,000 Incurred and paid lease expense for 2005. Lease Expense (E, –SE) .................................................................. 10,000 Cash (–A) ................................................................................... 10,000 Incurred and paid lease expense for 2006. Lease Expense (E, –SE) .................................................................. 10,000 Cash (–A) ................................................................................... 10,000 Incurred and paid lease expense for 2007. 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. 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 2005. ($39,927/5) Lease Liability (-L) ............................................................................ 6,805.84 Interest Expense (E, -SE) ................................................................ 3,194.16 Cash (-A) .................................................................................... 10,000 Made lease payment for 2005. Depreciation Expense (E, –SE) ....................................................... 7,985.40 Accumulated Depreciation (–A) ................................................. 7,985.40 Record depreciation of capitalized asset for 2006. Lease Liability (-L) ............................................................................ 7,350.32 Interest Expense (E, -SE) ................................................................ 2,649.68 Cash (-A) .................................................................................... 10,000 Made lease payment for 2006. Depreciation Expense (E, –SE) ....................................................... 7,985.40 Accumulated Depreciation (–A) ................................................. 7,985.40 Record depreciation of capitalized asset for 2007. Lease Liability (-L) ............................................................................ 7,938.32 Interest Expense (E, -SE) .......................................................... 2,061.68 Cash (-A) .................................................................................... 10,000 Made lease payment for 2007. Depreciation Expense (E, –SE) ....................................................... 7,985.40 Accumulated Depreciation (–A) ................................................. 7,985.40 Record depreciation of capitalized asset for 2008. Lease Liability (-L) ............................................................................ 8,573.36 Interest Expense (E, -SE) ................................................................ 1,426.64 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) ............................................................................ 9,260.00 Interest Expense (E, -SE) ................................................................ 740.00 Cash (-A) .................................................................................... 10,000 Made lease payment for 2009. 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 2005 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. E11–23 a. Annual Rental Expense = Rental Expense per Car Number of Cars = $10,000 100 cars = $1,000,000 b. Present Value of Lease Payments $10,000 per Car 100 Cars x Present Value of an = Ordinary Annuity Factor for i = 10%, n = 5 = $1,000,000 3.7908 from Table 5 in Appendix B = $3,790,800 Automobiles (+A).......................................................................... 3,790,800 Lease Liability (+L) ................................................................. 3,790,800 Leased automobiles. c. Interest Expense = Lease Obligation 10% = $3,790,800 10% = $379,080 Depreciation Expense = Cost of Automobiles ÷ 5 Years = $3,790,800 ÷ 5 = $758,160 Total Rental Expense = Interest Expense + Depreciation Expense = $379,080 + $758,160 = $1,137,240 d. 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 2005 by $1,000,000 [from part (a)] for rent expense. Alternatively, classifying the lease as a capital lease would reduce net income by a total of $1,137,240 [from part (c)] 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, Tradeall'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. E11–23 Concluded e. Off-balance sheet financing refers to financing agreements that require future payments, yet are structured so that the financing arrangement does not meet any of the criteria for the financing arrangement to be reported as a liability. The substance of an operating lease is considered to be a rental agreement. This implies that a company does not incur an obligation under the lease until it actually uses the item being leased. Thus, the future obligations under the lease should not be reported as a liability. Alternatively, the substance of a capital lease is considered to be a purchase agreement. This implies that the company has, in substance, acquired an asset and that the lease is simply a note payable for the acquisition of that asset. Thus, the present value of the future cash outflows specified in the lease agreement should be reported as a liability. The difference between operating and capital leases provides a way for companies to engage in off-balance-sheet financing. That is, by structuring a lease agreement as an operating lease, the lessee can engage in off-balance sheet financing. E11–24 a. Since the face value of the bank loan equals the proceeds of the loan (i.e., $149,388), the effective interest rate is equal to the stated interest rate. Therefore, the appropriate effective interest rate for Watts Motors for a ten-year borrowing arrangement is 12%. This rate should also be used for the lease. The annual lease payments would be an ordinary annuity for i = 12% and n = 10. Setting up the following formula and solving for the payment amount gives us the annual lease payment that would equate the two financing options. $149,388 = Lease Payment Present Value of an Ordinary Annuity Factor for i = 12% and n = 10 $149,388 = Lease Payment 5.65022 (from Table 5 in Appendix B) Lease payment = $26,439.32 (rounded) b. With the lease payment, Watts Motors would pay $26,439.32 at the end of each year for ten years. With the bank loan, Watts Motors would make interest payments of $17,926.56 ($149,388 12%) at the end of each year for ten years and a payment of $149,388 at the end of Year 10. The essential difference between the two financing arrangements is that a portion of every lease payment is applied against the outstanding principal balance while the annual payments under the bank loan do not reduce the principal balance. c. Option 1 Building (+A) ..................................................................................... 149,388 Notes Payable (+L) .................................................................... 149,388 Purchased a building. Option 2 Assets Acquired Under Capital Leases (+A) ................................... 149,388 Obligations Under Capital Leases (+L) ..................................... 149,388 Acquired a building under a capital lease. Option 3 Under the operating lease, the building would not be capitalized. Instead, on every lease payment date, Watts Motors would debit Lease Expense or Rent Expense for $26,439 and credit Cash for the same amount. E11–24 Concluded d. Payment Interest Expensea Principal Reductionb Principal $149,388.00 $26,439.32 $17,926.56 $8,512.76 140,875.24 26,439.32 16,905.03 9,534.29 131,340.95 a Interest Expense = Principal Effective Interest Rate of 12% b Principal Reduction = Payment – Interest Expense e. Present Value = $26,439.32 Present Value of an Ordinary Annuity Factor for i = 12% and n = 8 = $26,439.32 4.96764 (from Table 5 in Appendix B) = $131,341.02 The present value of the future lease payments equals the amount reported on the balance sheet calculated in part (d). E11–25 Present Value = Present Value of Face Value + Present Value of Interest Payment = (Face Value Present Value Factor) + (Periodic Interest Payment Present Value of an Ordinary Annuity Factor) Note 1 Since the proceeds (i.e., present value) equal the face value, we know that the effective rate equals the stated rate. Consequently, the effective rate for Note 1 is 8%. As proof: Present value (i = 8%, n = 6) PV of face value ($10,000 .63017 from Table 4 in Appendix B) .................... $ 6,301.70 PV of interest payments [($10,000 8%) 4.62288 from Table 5 in Appendix B] ....... 3,698.30 Total present value (i.e., proceeds) ............................................ $ 10,000.00 Note 2 $35,056 = ($100,000 Present Value Factor) + [($100,000 0%) Present Value of an Ordinary Annuity Factor] PV factor PV Factor = $35,056 ÷ $100,000 PV Factor = .35056 Examining Table 4 in Appendix B (i.e., present value of $1 table) for n = 8, we find that the effective rate is 14%. E11–25 Concluded Note 3 $922 = ($1,000 Present Value Factor) + [($1,000 7%) Present Value of an Ordinary Annuity Factor] Since the proceeds (i.e., present value) are less than the face value, we know that the note was issued at a discount. Consequently, the effective rate must be more than the stated rate. Try i = 9% for n = 5: ($1,000 .64993 from Table 4 in Appendix B) + [($1,000 7%) 3.88965 from Table 5 in Appendix B)] = $649.93 + $272.28 = $922 (rounded) Therefore, the annual effective interest rate must be 9%. Bond 1 $11,635 = ($10,000 Present Value Factor) + [($10,000 3%) Present Value of an Ordinary Annuity Factor] Since the proceeds are greater than the face value, we know that the bond was issued at a premium. Consequently, the effective rate is less than the stated rate. Try i = 2% for n = 20: ($10,000 .67297 from Table 4 in Appendix B) + [($10,000 3%) 16.35143 from Table 5 in Appendix B] = $6,729.70 + $4,905.43 = $11,635 (rounded) The effective rate per period is 2%. Since there are two interest periods per year, the annual effective interest rate is 4%. Bond 2 $54,323 = ($50,000 Present Value Factor) + [($50,000 4.5%) Present Value of an Ordinary Annuity Factor] Since the proceeds (i.e., present value) are greater than the face value, we know that the bond was issued at a premium. Consequently, the effective rate must be less than the stated rate. Try i = 4% for n = 30: ($50,000 .30832 from Table 4 in Appendix B) + [($50,000 4.5%) 17.29203 from Table 5 in Appendix B] = $15,416.00 + $38,907.07 = $54,323 (rounded) The effective rate per period is 4%. Since there are two interest periods per year, the annual effective interest rate is 8%. E11–26 a. Since the bonds have a face value of $1,000 and they are selling for 89.16, an individual bond would have a present value of $891.60 ($1,000 x 89.16%). For these bonds to be attractive to an investor who requires an annual rate of return of 12%, the present value of the bonds' future cash flows discounted using a discount rate of 6% semiannually must be greater than or equal to $891.60. If the present value is less, the bonds would not provide an annual rate of return of at least 12%. The present value of the bonds using a discount rate per six-month period of 6% is: Present value (i = 6%, n = 16) PV of maturity receipt ($1,000 .39365).................................................................... $ 393.65 PV of interest receipts [($1,000 4%) 10.10590) .................................................... 404.24 Total present value ........................................................................... $ 797.89 Since the present value of the future cash flows is less than $891.60, the bonds are providing an annual rate of return of less than 12%. Thus, the bonds do not provide the required rate of return, and they should not be considered for investment purposes. b. The annual effective interest rate that would make an investor indifferent to purchasing the bonds at 89.16 would be 10%, which implies a six-month rate of 5%. As proof: Present value (i = 5%, n = 16) PV of maturity receipt ($1,000 .45811).................................................................... $ 458.11 PV of interest receipts [($1,000 4%) 10.83777) .................................................... 433.51 Total present value (i.e., proceeds) ................................................. $ 891.62 At an annual effective rate of 10%, an investor would be indifferent to purchasing the bonds. E11–27 a. Bonneville issued the debt at a fixed rate, meaning that its outlay for interest will not change even if market interest rates change. A drop in market rates would not lower the interest paid by Bonneville; therefore, such a drop would increase the liability on the books of the company. In effect, the company would be paying above-market rates for its debt due to the fixed nature of the contract. b. Bonneville could manage the risk of fluctuating interest rates (and debt values) by entering into a hedging agreement known as an interest rate swap. Under a swap arrangement, Bonneville would agree with a counter party, most likely a large commercial bank, to receive periodic payments at a fixed rate of interest while also agreeing to pay out periodic payments that are tied to a floating rate of interest (Treasury Bills, for example). If market rates increase over the time period, Bonneville will make larger periodic payments under the swap agreement, while a drop in market rates will reduce the amount that Bonneville remits in periodic interest payments; regardless of changes in market rates, Bonneville will receive the same fixed payment from the counter party. The fixed payment received under the swap agreement will match what the stated rate of interest requires Bonneville to pay in the long term debt contract. The effect of the interest rate swap is to hedge against changes in debt values due to changes in market rates; the variable interest payments from the swap agreement effectively eliminate those market value changes. PROBLEMS P11–1 a. The present value of the future cash flows of this note equals $20,000. Since the effective rate of 10% equals the stated rate of 10%, the note will be issued at par value. Consequently, the face value of this note would be $20,000. b. The present value of the future cash flows of this note equals $20,000. Since the effective rate of 10% exceeds the stated rate of 0%, the note will be issued at a discount. The task is to determine what amount of cash paid at the end of two years discounted at 10% would equal $20,000 today. In other words, $20,000 = (Face Value Present Value Factor for i = 10%, n = 2) $20,000 = Face Value .8264 (from Table 4 in Appendix B) Face value = $24,201 (rounded) Consequently, the face value of this note would be $24,201. c. Note A Cash (+A) ......................................................................................... 20,000 Notes Payable (+L) .................................................................... 20,000 Issued note payable for cash. Note B Cash (+A) ......................................................................................... 20,000 Discount on Notes Payable (–L) ...................................................... 4,202 Notes Payable (+L) .................................................................... 24,202 Issued note payable for cash. d. Note A Interest Expense (E, –SE) ............................................................... 2,000* Cash (–A) ................................................................................... 2,000 Made interest payment. * $2,000 = $20,000 10% Notes Payable (–L) .......................................................................... 20,000 Cash (–A) ................................................................................... 20,000 Made principal payment on note payable. Note B Interest Expense (E, –SE) ............................................................... 1,782* Discount on Notes Payable (+L) ................................................ 1,782 Amortized discount on notes payable. * $1,782 = $4,202 Initial discount – $2,420 discount amortized during 2006 Notes Payable (–L) .......................................................................... 24,202 Cash (–A) ................................................................................... 24,202 Made principal payment on note payable. P11–2 a. The bonds will be issued at a discount. The bond market has determined that purchasers of Hartl Enterprises' bonds should earn an annual return on their investment of 10%. However, Hartl Enterprises is offering interest equal to only 8%. Since the stated interest rate cannot be changed, the only way that the investors can earn their 10% return is to invest a smaller amount in Hartl Enterprises. They will still receive the same future cash flows. Consequently, the bonds will be issued at a price that allows the investors to earn a return of exactly 10% on their investment. b. Face value .................................................................................... $ 10,000 Present value (i = 5%, n = 20) PV of maturity receipt ($10,000 .3769 from Table 4 in Appendix B) .................. $ 3,769 PV of interest receipts ($400 12.4622 from Table 5 in Appendix B) ................... 4,985 Total present value ....................................................................... 8,754 Discount ....................................................................................... $ 1,246 Cash (+A) ......................................................................................... 8,754.00 Discount on Bonds Payable (–L) ..................................................... 1,246.00 Bonds Payable (+L) ................................................................... 10,000.00 Issued bonds. c. Interest Expense (E, –SE) ............................................................... 218.85a Discount on Bonds Payable (+L) ............................................... 18.85b Interest Payable (+L).................................................................. 200.00c Accrued interest payable. a $218.85 = Book value Effective rate per period Portion of period outstanding = $8,754 5% 3/6 b $18.85 = Interest expense – Interest payable c $200.00 = Face value Stated rate per period Portion of period outstanding = $10,000 4% 3/6 d. Interest Expense (E, –SE) ............................................................... 218.85 Interest Payable (–L) ........................................................................ 200.00 Discount on Bonds Payable (+L) ............................................... 18.85 Cash (–A) ................................................................................... 400.00 Made interest payment. P11–3 a. L-T Debt/Equity Ratio = Total Long-Term Liabilities ÷ Total Stockholders' Equity = $40,000 ÷ $100,000 = 0.4 b. Proceeds = Present Value of Future Cash Flows Discounted at 11% for 5 Periods = $40,000 .59345 (from Table 4 in Appendix B) = $23,738 If Manheim Corporation borrows this $40,000, its long-term debt/equity ratio would be .637 [($40,000 + $23,738) ÷ $100,000]. c. Proceeds = Present Value of Future Cash Flows Discounted at 4% for 40 Periods = Present Value of the Face Value + Present Value of Interest Payments = ($40,000 .20829 from Table 4 in Appendix B) + [($40,000 5%) 19.79277 (from Table 5 in Appendix B)] = $8,332 + $39,586 = $47,918 If Manheim Corporation issues these bonds, its long-term debt/equity ratio would be .879 [($40,000 + $47,918) ÷ $100,000]. P11–4 a. Note A Face value ................................................................................. $ 20,000 Present value (i = 10%, n = 5) PV of face value ($20,000 .6209 from Table 4) ....................................... $ 12,418 PV of interest receipts ($0 3.7908 from Table 5) .............................................. 0 Total present value (i.e., proceeds) .......................................... 12,418 Discount .................................................................................... $ 7,582 Note B Face value ................................................................................. $ 35,000 Present value (i = 10%, n = 8) PV of face value ($35,000 .4665 from Table 4 in Appendix B) ............... $ 16,328 PV of interest receipts ($2,800 5.3349 from Table 5 in Appendix B) ............... 14,938 Total present value (i.e., proceeds) .......................................... 31,266 Discount .................................................................................... $ 3,734 P11–4 Concluded Note C Face value ................................................................................. $ 50,000 Present value (i = 4%, n = 20) PV of face value ($50,000 .4564 from Table 4) ....................................... $ 22,820 PV of interest receipts ($2,000 13.5903 from Table 5) ..................................... 27,181 Total present value (i.e., proceeds) .......................................... 50,000 Discount/premium ..................................................................... $ 0 b. Note A Cash (+A) ......................................................................................... 12,418.00 Discount on Notes Payable (–L) ...................................................... 7,582.00 Notes Payable (+L) .................................................................... 20,000.00 Issued notes payable for cash. Note B Cash (+A) ......................................................................................... 31,266.00 Discount on Notes Payable (–L) ...................................................... 3,734.00 Notes Payable (+L) .................................................................... 35,000.00 Issued notes payable for cash. Note C Cash (+A) ......................................................................................... 50,000.00 Notes Payable (+L) .................................................................... 50,000.00 Issued notes payable for cash. c. Interest Expense (E, –SE) ............................................................... 2,000.00 Cash (–A) ................................................................................... 2,000.00 Incurred and paid interest. d. Note B Interest Expense (E, –SE) ............................................................... 3,126.60a Discount on Notes Payable (+L) ................................................ 326.60b Cash (–A) ................................................................................... 2,800.00c Incurred and paid interest. a $3,126.60 = Book Value Effective Rate per Period = ($35,000 – $3,734) 10% b $326.60 = Interest Expense – Interest Payment c $2,800.00 = Face Value Stated Rate per Period = $35,000 8% P11–4 Continued Note C Interest Expense (E, –SE) ............................................................... 2,000.00 Cash (–A) ................................................................................... 2,000.00 Incurred and paid interest. e. Interest Expense (E, –SE) ............................................................... 1,241.80* Discount on Notes Payable (+L) ................................................ 1,241.80 Amortized discount on notes payable. _________________ * $1,241.80 = Book Value Effective Rate per Period = ($20,000 – $7,582) 10% P11–5 a. The effective interest rate can be calculated in two ways. The first way is by solving for i in each of the following equations. Note A: $37,566 = [$50,000 (1 + i)-3] Note B: $50,000 = [$50,000 (1 + i)-3] + {$5,000 [(1 - (1+ i)-3) ÷ i]} Note C: $45,027 = [$50,000 [(1 + i) -3] + {$3,000 [(1 - (1+ i)-3) ÷ i]} The second way is by trial and error. Plug an interest rate into the equations until the right- hand side of the equation equals the left-hand side. The annual effective interest rate is 10%. b. Interest Expense Interest Expense Interest Expense (Note A) (Note B) (Note C) Year 1 $ 3,756.60a $ 5,000.00 $ 4,502.70d Year 2 4,132.26b 5,000.00 4,652.97e Year 3 4,545.14c 5,000.00 4,817.33f Total $ 12,434.00 $ 15,000.00 $ 13,973.00 Interest Expense = Book Value at Beginning of Period Effective Rate a $3,756.60 = Initial Book Value of $37,566 10% b $4,132.26 = ($37,566 + $3,756.60) 10% c $4,545.14 = ($50,000 – $37,566) – ($3,756.60 + $4,132.26) d $4,502.70 = Initial Book Value of $45,027 10% e $4,652.97 = [$45,027 + ($4,502.70 – $3,000.00)] 10% f $4,817.33 = ($50,000 – $45,027) – ($4,502.70 – $3,000.00) – ($4,652.97 – $3,000.00) + $3,000 c. Note A Return Expense Income Year 1 $ 4,507.92a $ 3,756.60 $ 751.32 Year 2 5,048.88b 4,132.26 916.61 Year 3 5,654.73c 4,545.14 1,109.59 Total $ 15,211.52 $ 12,434.00 $ 2,777.52 a $4,507.92 = $37,566 12% b $5,048.87 = ($37,566 + $4,507.92) 12% c $5,654.73 = ($37,566 + $4,507.92 + $5,048.87) 12% P11–5 Concluded Note B Return Expense Income Year 1 $ 6,000.00a $ 5,000.00 $ 1,000.00 Year 2 6,720.00b 5,000.00 1,720.00 Year 3 7,526.40c 5,000.00 2,526.40 Total $ 20,246.40 $ 15,000.00 $ 5,246.40 a $6,000.00 = $50,000 12% b $6,720.00 = ($50,000 + $6,000) 12% c $7,526.40 = ($50,000 + $6,000 + $6,720) 12% Note C Return Expense Income Year 1 $ 5,403.24a $ 4,502.70 $ 900.54 Year 2 6,051.63b 4,652.97 1,398.66 Year 3 6,777.82c 4,817.33 1,960.49 Total $ 18,232.69 $ 13,973.00 $ 4,259.69 a $5,403.24 = $45,027 12% b $6,051.63 = ($45,027 + $5,403.24) 12% c $6,777.82 = ($45,027 + $5,403.24 + $6,051.63) 12% d. Total Debt = Current Liabilities as of 12/31/06 + (Long-Term Liabilities as of 12/31/06 + Face Value of Notes Payable – Discount Balance) Total Stockholders' Equity = Stockholders' Equity as of 12/31/06 + Net Income Debt/Equity Ratio = Total Debt ÷ Total Stockholders' Equity Debt/Equity Debt/Equity Debt/Equity (Note A) (Note B) (Note C) 12/31/07 4.270 4.516 4.418 12/31/08 4.277 4.279 4.278 12/31/09 4.271 3.972 4.086 e. Boyton must consider at least four factors in deciding which note to issue. First, the company must consider the income that can be earned from the proceeds. Since Note B provides the largest proceeds, this note provides the highest net income. Second, the company must consider the cash outflow effects of each note. If the company did not have sufficient cash on hand to meet an interest or principal payment, it could be forced into bankruptcy. Since each note requires a payment at maturity of $50,000, the only difference between the notes is the periodic interest payments. In this case, Note A requires the lowest interest payments. Third, the company must consider the immediate effects on its debt/equity ratio. If the company has any existing debt with a debt covenant that specifies a maximum debt/equity ratio, one of the notes may cause the company to violate the debt covenant. In this case, Note A results in the lowest debt/equity ratio in the current year. Finally, the company must consider the trend in the debt/equity ratio over time. If the company needs or desires to issue additional debt in the future, it might be constrained by its future debt/equity ratio. Creditors might be wary of a company with too high of a debt/equity ratio. In this case, the decrease in the debt/equity ratio is greatest for Note B. P11–6 a. The Amount of Interest Payments = Face Value of Debt Stated Interest Rate = $800,000 10% = $80,000 b. When the note payable was issued, the stated interest rate did not equal the effective interest rate; the effective interest rate exceeded the stated interest rate. Consequently, the proceeds from the note were less than face value, so that the entire loan to Rix Driving Range and Health Club would actually earn the effective interest rate on its money. The excess of the face value over the proceeds gave rise to the Discount on Notes Payable, and from Rix's viewpoint, this account effectively represents prepaid interest. Over the life of the note, this discount will be amortized to Interest Expense. Consequently, the difference between the balance in Interest Expense and the cash paid out for interest payments represents the amortization of the Discount on Notes Payable. c. Interest Expense = Book Value at Beginning of the Period Effective Interest Rate $95,000 = ($800,000 – $70,000) Effective interest rate Rate = 13% (rounded) d. Interest Expense (E, –SE) ............................................................... 95,000 Discount on Notes Payable (+L) ................................................ 15,000 Cash (–A) ................................................................................... 80,000 Incurred and paid interest. P11–7 a. Face value ................................................................................ $ 20,000.00 Present value (i = 4%, n = 12) PV of cash payment at maturity ($20,000 0.6246 from Table 4 in Appendix B) ............ $ 12,492.00 PV of cash interest payments ($600 9.3851 from Table 5 in Appendix B) ................. 5,631.06 Total present value ................................................................... 18,123.06 Discount on bonds ................................................................... $ 1,876.94 b. Face value ................................................................................ $ 20,000.00 Present value (i = 4%, n = 11) PV of cash payment at maturity ($20,000 0.6496 from Table 4 in Appendix B) ............ $ 12,992.00 PV of cash interest payments ($600 8.7605 from Table 5 in Appendix B) ................. 5,256.30 Total present value ................................................................... 18,248.30 Discount on bonds ................................................................... $ 1,751.70 The present value of the cash flows on these bonds as of December 31, 2006, using the effective interest rate on the date the bonds were originally issued, represents the book value of the bonds as of December 31, 2006. c. The difference of $125.24 in present values from June 30, 2006 and December 31, 2006 represents the change in book value of these bonds for this six-month period. The change in book value would be captured by the amortization of the Discount on Bonds Payable account. P11–7 Concluded d. Interest Expense (E, –SE) ............................................................... 724.92a Discount on Bonds Payable (+L) ............................................... 124.92b Cash (–A) ................................................................................... 600.00c Incurred and paid interest. a $724.92 = Book Value Effective Rate per Period = $18,123.06 4% b $124.92 = Interest Expense – Interest Payment c $600.00 = Face Value Stated Rate per Period = $20,000 3% The amount of discount on bonds payable is essentially the same as the amount in part (c); the difference of 32¢ is due to rounding. Under the effective-interest method, bonds are carried on the balance sheet at their present value (based upon the effective rate at the initial date of issue) at that particular point in time. Hence, it makes no difference if one computes the present value of the cash outflows associated with bonds or applies the effective-interest method; both methods will yield essentially identical financial statements. P11–8 a. To compute the amount of money that Ross Running Shoes must invest on June 30, 2006, the future cash flows must be discounted at the investment rate of 8%. Since the investment rate is an annual rate, and interest is paid semiannually, the rate must be adjusted to a six-month rate of 4%. Therefore, i = 4% and n = 6. Present Value = Present Value of Face Value + Present Value of Interest Payments = ($10,000 .79031 from Table 4 in Appendix B) + [($10,000 5%) 5.24214 from Table 5 in Appendix B] = $7,903.10 + $2,621.07 = $10,524.17 b. Interest Expense (E, –SE) ............................................................... 420.97a Premium on Notes Payable (–L)...................................................... 79.03b Cash (–A) ................................................................................... 500.00c Incurred and paid interest. a $420.97 = Book Value Effective Rate per Period = ($10,000 + $524.17) 4% b $79.03 = Interest Expense – Interest Payment c $500.00 = Face Value Stated Rate per Period = $10,000 5% c. Interest Expense (E, –SE) ............................................................... 412.64a Premium on Notes Payable (–L)...................................................... 87.36b Cash (–A) ................................................................................... 500.00c Incurred and paid interest. a $412.64 = Interest Payment – Premium Amortization b $87.36 = Total Premium ÷ Number of 6-Month Periods = $524.17 ÷ 6 periods c $500.00 = Face Value Stated Rate per Period = $10,000 5% P11–8 Concluded d. Under the effective-interest method, the company will recognize interest expense during 2006 of $420.97 [from part (b)]. Under the straight-line method, the company will recognize interest expense during 2006 of $412.64 [from part (c)]. Thus, the straight-line method results in lower expenses and higher net income in the early periods of a note issued at a premium. e. Over the life of a note or bond, both the effective-interest and straight-line methods will amortize the entire discount or premium balance. Consequently, over the life of a note or bond, both methods will amortize exactly the same amount of discount or premium. As noted in part (d), for notes issued at a premium, the straight-line method will recognize lower interest expense than the effective-interest method in the early years of the note's life. The lower interest expense recognized under the straight-line method will eventually have to be offset if both methods are to recognize the same amount of interest expense over the life of the note. Consequently, the straight-line method will have to recognize ―relatively‖ higher interest expense and, hence, lower net income in the later years of a note issued at a premium. P11–9 a. Note A 1/1/06 12/31/06 Present value (i = 6%, n = 3) Present value (i = 6%, n = 2) PV of face value PV of face value ($1,000 .8396) $ 839.60 ($1,000 .8900) $ 890.00 PV of interest payment PV of interest payment ($100 2.6730) 267.30 ($100 1.8334) 183.34 Total present value $ 1,106.90 Total present value $ 1,073.34 12/31/07 Present value (i = 6%, n = 1) PV of face value ($1,000 .9434) $ 943.40 PV of interest payment ($100 .9434) 94.34 Total present value $ 1,037.74 Note B 1/1/06 12/31/06 Present value (i = 10%, n = 3) Present value (i = 10%, n = 2) PV of face value PV of face value ($1,000 .75132) $ 751.32 ($1,000 .83645) $ 826.45 PV of interest payment PV of interest payment ($100 2.48685) 248.69 ($100 1.73554) 173.55 Total present value $ 1,000.00 Total present value $ 1,000.00 12/31/07 Present value (i = 10%, n = 1) PV of face value ($1,000 .90909) $ 909.10 PV of interest payment ($100 .90909) 90.91 Total present value $ 1,000.00 P11–9 Continued Note C 1/1/06 12/31/06 Present value (i = 10%, n = 3) Present value (i = 10%, n = 2) PV of face value PV of face value ($1,000 .75132) $ 751.32 ($1,000 .82645) $ 826.45 PV of interest payment PV of interest payment ($60 2.48685) 149.21 ($60 1.73554) 104.13 Total present value $ 900.53 Total present value $ 930.58 12/31/07 Present value (i = 10%, n = 1) PV of face value ($1,000 .90909) $ 909.09 PV of interest payment ($60 .90909) 54.55 Total present value $ 963.64 b. Interest Payment Disc./Prem. Face Disc./Prem. Book Date Expense Amount Amortization Value Balance Value Note A 1/1/06 $1,000.00 $106.90 $1,106.90 12/31/06 $66.42 $100.00 $33.58 1,000.00 73.32 1,073.32 12/31/07 64.40 100.00 35.60 1,000.00 37.71 1,037.73 12/31/08 62.26 100.00 37.74 1,000.00 ($0.00) 1,000.00 Note B 1/1/06 $1,000.00 $0.00 $1,000.00 12/31/06 $100.00 $100.00 $0.00 1,000.00 0.00 1,000.00 12/31/07 100.00 100.00 0.00 1,000.00 0.00 1,000.00 12/31/08 100.00 100.00 0.00 1,000.00 0.00 1,000.00 Note C 1/1/06 $1,000.00 $99.48 $900.52 12/31/06 $90.05 $60.00 $30.05 1,000.00 69.43 930.57 12/31/07 93.06 60.00 33.06 1,000.00 36.37 963.63 12/31/08 96.36 60.00 36.37 1,000.00 ($0.00) 1,000.00 P11–9 Concluded c. Interest Payment Disc./Prem. Face Disc./Prem. Book Date Expense Amount Amortization Value Balance Value Note A 1/1/06 $1,000.00 $106.90 $1,106.90 12/31/06 $64.37 $100.00 $35.63 1,000.00 71.27 1,071.27 12/31/07 64.37 100.00 35.63 1,000.00 35.63 1,035.63 12/31/08 64.37 100.00 35.63 1,000.00 0.00 1,000.00 Note B 1/1/06 $1,000.00 $0.00 $1,000.00 12/31/06 $100.00 $100.00 $0.00 1,000.00 0.00 1,000.00 12/31/07 100.00 100.00 0.00 1,000.00 0.00 1,000.00 12/31/08 100.00 100.00 0.00 1,000.00 0.00 1,000.00 Note C 1/1/06 $1,000.00 $99.48 $900.52 12/31/06 $26.84 $60.00 $33.16 1,000.00 66.32 933.68 12/31/07 26.84 60.00 33.16 1,000.00 33.16 966.84 12/31/08 26.84 60.00 33.16 1,000.00 ($0.00) 1,000.00 d. Compare parts (b) and (c) to part (a). The effective interest method maintains the net book value of the liability equal to the present value of the future cash flows of the liability throughout the liability's life. Alternatively, the straight-line method does not maintain this equality. Further, under the effective interest method, interest expense is always the same percentage of the outstanding debt throughout the life of the liability. This constant relationship arises because interest expense is computed as the book value times the effective interest rate, and since the effective interest rate is assumed to be constant, interest expense remains a constant percentage of the liability. The straight-line method does not result in this constant relationship between interest expense and the outstanding liability, as evidenced by the amounts reported under interest expense in part (c). P11–10 a. Book Value of Debt = Face Value of $500,000 + Premium Balance of $12,600 = $512,600 Cash Paid to Retire Debt = Face Value 104% = $500,000 104% = $520,000 Loss = Excess of Cash Paid Over Book Value = $512,600 – $520,000 = $7,400 b. Cash Paid to Retire Debt = Face Value 108% = $500,000 108% = $540,000 P11–10 Concluded Loss = Excess of Cash Paid Over Book Value = $540,000 – $512,600 = $27,400 c. Ginny and Bill Eateries is required to make an interest payment on June 30, 2006 under the terms of the debt agreement. The entry to record this payment would be: Interest Expense (E, –SE) ............................................................... 15,378a Premium on Bonds Payable (–L) ..................................................... 4,622b Cash (–A) ................................................................................... 20,000c Incurred and paid interest. a $15,378 = Book Value Effective Rate per Period = $512,600 3% b $4,622 = Interest Expense – Interest Payment c $20,000 = Face Value Stated Rate per Period = $500,000 4% Book Value of Debt = Face Value + Premium Balance = $500,000 + ($12,600 – $4,622) = $507,978 Cash Paid to Retire Debt = Face Value 110% = $500,000 110% = $550,000 Loss = Excess of Cash Paid Over Book Value = $550,000 – $507,978 = $42,022 P11–11 a. Face value ................................................................................. $ 5,000.00 Present value (i = 7%, n = 10) PV of face value ($5,000 .5083 from Table 4 in Appendix B) ................. $ 2,541.50 PV of interest payments ($300 7.0236 from Table 5 in Appendix B) .................. 2,107.08 Total present value (i.e., proceeds) .......................................... 4,648.58 Discount .................................................................................... $ 351.42 Cash (+A) ......................................................................................... 4,648.58 Discount on Bonds Payable (–L) ..................................................... 351.42 Bonds Payable (+L) ................................................................... 5,000.00 Issued bonds. P11–11 Continued b. Interest Expense (E, –SE) ............................................................... 325.40a Discount on Bonds Payable (+L) ............................................... 25.40b Cash (–A) ................................................................................... 300.00c Incurred and paid interest. a $325.40 = Book Value Effective Rate per Period = $4,648.58 7% b $25.40 = Interest Expense – Interest Payment. c $300.00 = Face Value Stated Rate per Period = $5,000 6% c. As of June 30, 2008, the bonds have a remaining life of five six-month periods until they mature. Option 1: Repurchase the bonds through the bond market. Present value (i = 5%, n = 5) PV of face value ($5,000 .7835 from Table 4 in Appendix B) ................. $ 3,917.50 PV of interest payments ($300 4.3295 from Table 5 in Appendix B) .................. 1,298.85 Total present value (i.e., repurchase price) .............................. $ 5,216.35 Option 2: Repurchase the bonds using the call provision. Repurchase Price = Face Value 103.5% = $5,000 103.5% = $5,175.00 In this case, Ficus Tree Farm would have to use less cash to redeem the bonds using the call provision than to repurchase them through the bond market. Consequently, the company should use the call provision to redeem the bonds. d. Assume that a company wishes to redeem all outstanding bonds prior to maturity. It is unlikely that it could accomplish this goal by repurchasing the bonds through the bond market. Some bondholders would simply be unwilling to sell the bonds. It is costly for bondholders to sell their bonds and reinvest. They incur transaction costs (i.e., brokerage fees, etc.) when selling investments. It is also time-consuming (for example, the opportunity cost of researching new investment opportunities). Bondholders would also consider the tax implications of selling their bonds. If the bondholder would have to recognize any gains on the sale of the bond, these gains would be considered taxable income. To avoid these taxes, the bondholder may prefer to simply hold the bond. By exercising a call provision, a company can compel all bondholders to surrender their bonds. Consequently, if a company wishes to retire all outstanding bonds, the company will have to resort, at least partially, to exercising any relevant call provisions. P11–11 Concluded e. Bonds Payable (–L).......................................................................... 5,000.00 Extraordinary Loss on Redemption (E, –SE)................................... 380.35 Discount on Bonds Payable (+L) ............................................... 205.35* Cash (–A) ................................................................................... 5,175.00 Redeemed bonds. *see table Interest Payment Disc./Prem. Face Disc./Prem. Book Date Expense Amount Amortization Value Balance Value 1/1/06 $5,000.00 $351.42 $4,648.58 6/30/06 $325.40 $300.00 $25.40 5,000.00 326.02 4,673.98 1/1/07 327.18 300.00 27.18 5,000.00 298.84 4,701.16 6/30/07 329.08 300.00 29.08 5,000.00 269.76 4,730.24 1/1/08 331.12 300.00 31.12 5,000.00 238.64 4,761.36 6/30/08 333.30 300.00 33.30 5,000.00 205.35 4,794.65 P11–12 a. Face value .............................................................................. $ 100,000 Present value (i = 5%, n = 8) PV of face value ($100,000 .67684 from Table 4 in Appendix B) ........ $ 67,684 PV of interest payments ($3,000 6.46321 from Table 5 in Appendix B) .......... 19,390 Total present value ................................................................. 87,074 Discount ................................................................................. $ 12,926 a b c d Date Interest Expense Cash Payment Amortized Discount Book Value 12/31/06 $4,353,70 $3,000.00 $1,353.70 $ 88,427.70 6/30/07 4,421.39 3,000.00 1,421.39 89,849.09 12/31/07 4,492.45 3,000.00 1,492.45 91,341.54 6/30/08 4,567.08 3,000.00 1,567.08 92,908.62 12/31/08 4,645.43 3,000.00 1,645.43 94,554.05 6/30/09 4,727.70 3,000.00 1,727.70 96,281.75 12/31/09 4,814.09 3,000.00 1,814.09 98,095.84 6/30/10 4,904.79 3,000.00 1,904.79 100,000.00 a Interest Expense = Book Value at the Beginning of the Period Effective Rate per Period of 5% b Cash Payment = Face Value of $100,000 Stated Rate per Period of 3% c Unamortized Discount = Unamortized Discount at the Beginning of the Period – Excess of Interest Expense Over the Cash Payment d Book Value = Face Value of $100,000 – Unamortized Discount P11–12 Concluded b. Cash outflows Total interest payments = $3,000 8 payments = $24,000 Total principal payment = $100,000 on maturity of the bonds Total cash outflow = $24,000 + $100,000 = $124,000 Cash inflows Cash inflows = Proceeds received upon issuing the bonds = $87,073 Therefore, cash outflows exceed cash inflows by $36,927. c. Cash outflows Post-tax interest payments = [$3,000 (1 – tax rate)] 8 payments = [$3,000 (1 – 34%)] 8 payments = $15,840 Total principal payment = $100,000 on maturity of the bonds Total cash outflow = $15,840 + $100,000 = $115,840 Cash inflows Cash inflows = Proceeds received upon issuing the bonds = $87,073 Therefore, cash outflows exceed cash inflows by $28,767. d. Cash outflows Individual post-tax interest payments = $3,000 (1 – tax rate) = $1,980 Present value of post-tax payments = $1,980 Present value of an ordinary annuity for i = 5% and n = 8) = $1,980 6.4632 from Table 5 in App. A = $12,797 Total principal payment = $100,000 on maturity of the bonds Present value of principal payment = $67,684 [from part (a)] Total cash outflow = $12,797 + $67,684 = $80,481 Cash inflows Cash inflows = Proceeds received upon issuing the bonds = $87,073 Therefore, cash inflows exceed cash outflows by $6,592. P11–13 a. On the financial statements a capital lease is treated like the company had purchased the fixed assets. The asset and the related liability are recorded on the balance sheet and interest and depreciation are recorded on the income statement. An operating lease is treated like a recurring expense each month but nothing is recorded on the balance sheet. The amount of the lease payment is shown as an expense each month. b. A company may want to treat leases as operating leases because there is no debt that is recorded on the balance sheet. This treatment impacts a number of financial ratios (debt-to- equity, for example) and so may be to the company’s advantage to treat it like an operating lease. c. total liability ÷ total asset ratio if Wal-Mart treats these leases as: currently recorded: $61.3 ÷ $104.9 = 58.4% if all leases are capital leases: $66.9 (61.3 + 5.6) ÷ $110.5 (104.9 + 5.6) = 60.5% $3.2 ÷ $5.0 = 64.0%, 64% of $8.7 billion = $5.6 billion d. An analyst needs to be able to compare companies that use different methods for accounting for leases. If an analyst does not do this additional analysis there is a good chance that the analyst will be misled as to the relative performance of the companies. The more leases that the companies have on their books the more this differential between operating leases and capital leases could affect the analysis of the companies. A review of ―off-balance sheet financing‖ is always a prudent step in financial analysis. P11–14 a. The initial balance sheet value of the equipment and the initial leasehold obligation both equal the present value of the lease payments. This amount can be determined in the following ways. Present value of lease payments = FMV of equipment = $119,782 or Present value of lease payments = Present value of lease payments = $30,000 Present value of an ordinary annuity factor for i = 8% and n = 5 = $30,000 3.99271 (from Table 5 in Appendix B) = $119,781.30 P11–14 Concluded Balance Sheet Value of Leasehold Interest Depr. Total a Date Equipment Obligationb Expensec Expensed Expense 1/1/05 $119,781.30 $119,781.30 12/31/05 95,825.04 99,363.80 $9,582.50 $23,956.26 $33,538.76 12/31/06 71,868.78 77,312.91 7,949.10 23,956.26 31,905.36 12/31/07 47,912.52 53,497.94 6,185.03 23,956.26 30,141.29 12/31/08 23,956.26 27,777.78 4,279.84 23,956.26 28,236.10 12/31/09 (0.00) (0.00) 2,222.22 23,956.26 26,178.48 Total $30,218.70 $119,781.30 $150,000.00e a Balance Sheet Value of Equipment = Value of Equipment on 1/1/05 – Accum. deprec. b Leasehold Obligation = Leasehold Obligation at Beginning of the Period – ($30,000 Lease Payment – Interest Expense for the Period) c Interest Expense = Leasehold Obligation at Beginning of the Period 8% d Depreciation Expense = $119,781.30 ÷ 5 years e Total has penny discrepancy due to rounding to even cents throughout lease term. b. Total Rent Expense = Annual Rent Payments Number of Years of the Lease = $30,000 5 years = $150,000 c. If the lease is treated as a capital lease, total expenses would be $150,000 [from part (a)]. If the lease is treated as an operating lease, total expenses would still be $150,000 [from part (b)]. Although total expenses would be the same under either approach, different expense accounts are affected under the two approaches. With a capital lease, the $150,000 is allocated between interest expense and depreciation expense, while with an operating lease, the entire $150,000 is allocated to rent expense. P11–15 a. If the lease is treated as an operating lease, Thompkins Laundry would not have to report any liability associated with the lease. Therefore, its debt/equity ratio would be as follows. Debt/Equity Ratio = Total Liabilities ÷ Stockholders' Equity = (Current Liabilities + Long-Term Liabilities) ÷ Stockholders' Equity = $30,000 ÷ $40,000 = 0.75 b. If the lease is treated as a capital lease, Thompkins Laundry would have to report a liability equal to the present value of the future lease payments. Therefore, its debt/equity ratio would be affected. Present value of lease payments = $5,000 Present value of an ordinary annuity factor for i = 12% and n = 5 = $5,000 3.60478 (from Table 5 in Appendix B) = $18,023.90 Debt/equity ratio = ($30,000 + $18,023.90) ÷ $40,000 = 1.20 P11–15 Concluded c. Rent Interest Depreciation Total Expense Expense ___Expense_ Expenses Operating lease $5,000.00 $ 0.00 $ 0.00 $5,000.00 Capital lease 0.00 2,162.87 3,604.78 5,767.65 d. There are two primary reasons why Thompkins Laundry might want to arrange the terms of the lease agreement so that the lease would be classified as an operating lease rather than as a capital lease. First, lease obligations under an operating lease are not disclosed on the face of the balance sheet. Consequently, operating leases are essentially off-balance-sheet financing and will not affect any existing debt covenants that are based on reported liabilities. Second, in this case the capital lease classification results in higher expenses and, hence, lower net income in 2006 than the operating lease classification. Decreased net income would adversely affect any contracts, such as the manager's incentive contract, written on the basis of reported net income. To avoid classifying this lease as a capital lease, Thompkins Laundry would have to arrange the terms so that the lease did not meet any of the criteria for capital leases. Consequently, the company would have to arrange the terms so that: (1) the present value of the lease payments is less than 90% of the fair market value of the leased property; (2) the term of the lease is less than 75% of the leased property's life; (3) the lessee does not have the right either during or at the expiration of the lease agreement to purchase the property from the lessor at a nominal amount; or (4) ownership of the property is not transferred to the lessee from the lessor by the end of the lease term. (5) P11–16 a. Equipment (+A) ................................................................................ 17,604 Discount on Notes Payable (–L) ...................................................... 2,396 Notes Payable (+L) .................................................................... 20,000 Purchased equipment in exchange for a note. b. Present Value = Present Value of Maturity Payment + Present Value of Periodic Payments $17,604 = ($20,000 Present Value Factor) + ($1,000 Present Value of an Ordinary Annuity Factor) Since the present value of $17,604 is less than the face value, we know that the note was issued at a discount. Consequently, the effective rate is greater than the stated rate. We also know that the stated rate is 5% ($1,000 ÷ $20,000 face value). Try i = 6% for n = 5: ($20,000 .74726 from Table 4 in Appendix B) + ($1,000 4.21236 from Table 5 in Appendix B) = $14,945 + $4,212 = $19,158 Try i = 8% for n = 5 ($20,000 .68058 from Table 4 in Appendix B) + ($1,000 3.99271 from Table 5 in Appendix B) = $13,612 + $3,992 = $17,604 Therefore, the effective interest rate on the note is 8%. P11–16 Concluded c. Interest Expense (E, –SE) ............................................................... 1,408a Discount on Notes Payable (+L) ................................................ 408b Cash (–A) ................................................................................... 1,000 Incurred and paid interest. a $1,408 = Book Value Effective Rate per Period = ($20,000 – $2,396) 8% b $408 = Interest Expense – Interest Payment d. 12/31/06 Net Book Value = Face Value – 12/31/06 Discount on Notes Payable = $20,000 – ($2,396 – $408) = $18,012 P11–17 a. Since the bonds are selling at par value, the effective interest rate must be equal to the stated interest rate of 9%. The effective interest rate is the sum of two components: a risk-free component and a risk premium. It is given in the problem that the risk-free rate is 7%, which implies that the risk premium on Hodge Sports, bonds must be the difference between the effective interest rate of 9% and the risk-free rate of 7%, or 2%. b. If the risk premium increased from 2% to 5%, the effective interest rate would increase to 12%. A single bond would now be worth $889.59 to you, as calculated below. (Remember that bonds usually have a face value of $1,000 and pay interest semiannually.) Present value (i = 6%, n = 10) Present value of face value ($1,000 .55839 from Table 4 in Appendix B) ...................... $ 558.39 Present value of interest payments ($45 7.36009 from Table 5 in Appendix B) ......................... 331.20 Total present value ........................................................................... $ 889.59 c. A decrease in the prime interest rate would probably result in a drop in the effective interest rate used to discount the future cash flows of Hodge Sports’ bonds. As the effective interest rate drops, the stated interest rate looks relatively more attractive to investors. Thus, demand for the bonds should increase, which, in turn, should drive up the selling price of the bonds. A single bond would now be worth $1,040.55, as calculated below. Present value (i = 4%, n = 10) Present value of face value ($1,000 .67556 from Table 4 in Appendix B) ...................... $ 675.56 Present value of interest payments ($45 8.11090 from Table 5 in Appendix B) ......................... 364.99 Total present value ........................................................................... $ 1,040.55 P11–18 a. The effective interest rate on the bonds is 8%. The future value of the bond payments are $2,000 (semi-annual interest payment based on the stated rate of 4%) for four periods and $100,000 (principal due at maturity); the present value is the purchase price of $92,994. The effective rate of 8% discounts the future values to the present value. (The general present value formula of 1/[(1 + r) to the nth] was used in this calculation.) b. Cash 2,000 Bond Investment 1,720 Interest Revenue 3,720 Receipt of interest payment on 11/30/2005 (3,720 = Eff. Rate per period of 4% X $92,994) Cash 2,000 Bond Investment 1,789 Interest Revenue 3,789 Receipt of interest payment on 5/31/2006 (3,789 = Eff. Rate per period of 4% X [92,994 + 1,720]) c. On May 31, 2006 the book value of the investment is $96,503 (92,994 + 1,720 + 1,789). On the same date, if market interest rates are 6% the market value of the investment is $98,087 (PV of a $2,000 ordinary annuity, n=2, r = 3 plus PV of a single sum of $100,000, n = 2, r = 3). ISSUES FOR DISCUSSION ID11–1 a. A debenture is an unsecured bond. That is, there is no collateral supporting the bond. Thus, should the company not repay the bonds, investors do not have security in any of the company's assets that could be sold to repay the bonds. For this reason, unsecured bonds are riskier than secured bonds. Investors are compensated for this increased risk on debentures through a higher return (i.e., effective interest rate). Accordingly, these bonds would be priced lower than a secured bond in the same company. b. There are three general reasons why a company would repurchase its outstanding debt. First, the company may no longer need the money it borrowed. By repurchasing the debt, the company could avoid incurring interest. Second, due to a decrease in interest rates, the company may have repurchased its debt with the intent of issuing new debt at the lower prevailing interest rates. Finally, the company may repurchase some of its debt in an effort to improve its balance sheet. This would generally be in an effort to improve some financial ratios specified in debt covenants. c. Repurchasing debt would decrease both a company's liabilities (due to the amount of debt repurchased) and its assets (due to the cash paid out to repurchase the debt). For Sun Company, its stockholders' equity would also decrease because it paid out $957.50 for each bond when the book value of a bond was only $875. Thus, Sun Company would have a loss of $82.50 on each bond repurchased, which would decrease stockholders' equity through closing the loss into Retained Earnings. d. Sun Company would not have recognized any loss if it had not repurchased its debt. Unless there is evidence to the contrary, such as a company repurchasing its debt, accountants assume that when a company issues debt, the debt will remain outstanding until it matures. This implies that changes in the market value of the debt are irrelevant to the financial position of the company as reported in its financial statements. ID11–2 a. The stated interest rate affects only the magnitude of periodic interest payments. What is important to investors is the rate of return on their investments. Thus, if an investor is not in need of periodic cash payments, a non-interest-bearing obligation that provides a competitive rate of return is an attractive investment option. b. The rate that discounts $200 million due in eight years to a present value of $66.48 million is 14.75%. c. If bonds have a stated rate, the company has to have sufficient cash flow to make the periodic interest payments. Thus, if a company does not expect to have sufficient cash flows to support periodic interest payments, it is to the company's advantage to issue bonds with a stated interest rate of zero. ID11–2 Concluded d. To simplify the calculations, the effective interest rate of 14.75% [see part (b)] is rounded to 15%. 5% stated rate Present value of $200 million paid in 8 years $200 million .32690 (from Table 4 in Appendix B) ......................... $ 65,380,000 Present value of periodic interest payments ($200 million 5%) 4.48732 (from Table 5 in Appendix B) ........... 44,873,200 Issue price ............................................................................................. $ 110,253,200 18% stated rate Present value of $200 million paid in 8 years $200 million .32690 (from Table 4 in Appendix B) ......................... $ 65,380,000 Present value of periodic interest payments ($200 million 18%) 4.48732 (from Table 5 in Appendix B) ......... 161,543,520 Issue price ............................................................................................. $ 226,923,520 ID11–3 a. The effective interest rate is the interest rate that equates the undiscounted future cash flows with the present value of the future cash flows. For both alternatives, the undiscounted cash flows are only the fifteen annual payments of $6 million each, and the present value of both alternatives is the $45,636,480 price of the jet plane. The equation to equate the undiscounted future cash flows and the present value is as follows. $45,636,480 = $6,000,000 {[1– (1 + i)-15] ÷ i]} Solving for i mathematically or by trial and error indicates that the annual effective interest rate is 10%. b. Cash (+A) ............................................................................... 45,636,480 Note Payable (+L) ............................................................ 45,636,480 Issued note payable. Airplane (+A) .......................................................................... 45,636,480 Cash (–A) ......................................................................... 45,636,480 Purchased airplane. c. Airplanes Capitalized Under Leases (+A) ............................. 45,636,480 Lease Liability (+L) ........................................................... 45,636,480 Leased airplane. d. If Southwest Airlines borrows the necessary funds and then purchases the airplane, Southwest's fixed assets and liabilities would both increase by $45,636,480. In addition, Southwest would have to depreciate the airplane. The effect on the financial statements would be identical if Southwest leases the airplane, and the lease is considered to be a capital lease. e. Southwest Airlines would not have to prepare any journal entry when it signs the lease if the lease is considered to be an operating lease. ID11–3 Concluded f. Structuring the leasing arrangement as an operating lease would be an example of off-balance sheet financing. With an operating lease, the substance of the lease arrangement is that Southwest is renting the airplane from the Boeing Company. Thus, Southwest is not considered to have any obligation to Boeing until Southwest actually uses the airplane. As Southwest uses the airplane, Southwest should record rent expense. This means that Southwest would never report any liability on its balance sheet associated with the future payments required under the lease agreement. Thus, Southwest would be able to finance the "acquisition" of an airplane without having to report any liability associated with acquiring the airplane. Southwest would most likely engage in off-balance sheet financing in order to prevent an increase in the amount of reported debt. By limiting any increases in reported debt, the company decreases the chance it would violate any debt covenants that specify a maximum debt/equity ratio. In addition, reporting less debt would make Southwest appear to be a less risky investment option. Since the return a company must pay on investment capital is positively associated with the risks of the company, anything that would make Southwest appear to be less risky should decrease its cost of capital. The real question, however, is whether potential investors, in evaluating investment alternatives, focus solely on the debt reported on the balance sheet or, instead, focus on the company's obligations reported in the footnotes to the financial statements. The footnotes would usually disclose any major obligations under operating leases. ID11–4 a. The current portion of Long Term Debt ($224) appeared in the Current Liabilities section of the balance sheet; the rest of the Long Term Debt, totaling $2,955, appeared in the long-term liabilities section of Johnson & Johnson’s balance sheet. b. A zero coupon debenture is a debt instrument that has a stated rate of interest of 0%. The debenture contract only requires the repayment of the face amount at maturity. However, because no company borrows at zero percent, the debentures are sold at a discount depending on the effective rate of interest. The zero coupon debenture that are due in 2014 carry an effective interest rate of 5.25%, higher than the zero coupon debentures due in 2020, and therefore were issued at a larger discount relative to the face amount of the debt instrument. The present value of the single sum due at maturity is discounted further when a larger effective interest rate is applied (see Table 4, Present Value of a Single Sum). c. A bond contract with a stated rate of interest equal to the effective rate of interest will be sold at par (no discount or premium). The 2033 debentures, the 2013 debentures, the 2024 debentures, and the 2023 debentures are carry effective rates equal to their stated rates, therefore selling at par. d. The 6.95% notes due in 2029 were issued with an effective rate of interest of 7.14%, which is in excess of the stated rate of 6.95%. Therefore, the notes were sold at a discount, meaning that the face amount is greater than the balance sheet amount of $293. ID11–5 a. A large amount of debt forces a company's management to place greater emphasis on generating cash so that it has sufficient cash to make the required interest and principal payments. Thus, a company may alter its operating, investing, and financing decisions to allow it to generate the cash it needs when it needs it. b. The massive borrowing activity during the 1980s would have manifested itself as increased liabilities on the companies' balance sheets. By analyzing different companies' current ratios and debt/equity ratios, which are measures of a company's solvency, potential investors may have been able to identify those companies that were taking on an excessive amount of debt. However, even this type of analysis may not have been sufficient to identify overly risky companies. Companies will often engage in off-balance sheet financing, such as structuring leasing arrangements as an operating lease. Companies are most likely to engage in off- balance sheet financing when they are close to violating existing debt covenants that specify a maximum debt/equity ratio or when the company already has a large amount of debt. Since, by definition, off-balance sheet financing does not show up on the balance sheet as a liability, it will not be reflected in either the current ratio or the debt/equity ratio. An alternative analysis strategy investors could have used was to examine the statement of cash flows to determine whether the company was consistently generating enough cash from operating activities to service its debt. This approach is good in that any cash payments associated with off-balance sheet financing will be reflected on the statement of cash flows. The negative aspect of this analysis approach is that the analysis cannot be adequately performed until the company is making interest and principal payments. By this time it may be too late! c. A debenture is an unsecured bond. That is, there is no collateral supporting the bond. Thus, should the company not repay the bonds, investors in debentures, unlike investors in secured bonds, do not have security in any of the company's assets that could be sold to repay the bonds. In other words, in the event a company liquidates, the secured creditors are paid before the unsecured creditors. This means that if the company does not have sufficient cash available after liquidating to repay both the secured creditors and the holders of debentures, it is the latter group that will not receive full payment. ID11–6 a. Albertson’s Safeway Liabilities $10.0 billion $11.4 billion Total assets $15.4 billion $15.1 billion Liabilities/total assets ratio 0.65 0.75 b. If all leases are capital leases: Albertson’s Safeway Liabilities $10.000 billion $11.4000 billion + Lease liabilities 0.350 billiona 0.399 billionb Total liabilities $10.350 billion $11.799 billion Assets $15.4 billion $15.100 billion + Lease liabilities 0.350 billiona 0.399 billionb Total Assets $15.75 billion $15.499 billion Adjusted liabilities/total assets ratio 0.66 0.76 a ($402 million in lease payments 87% operating) = $349.7 million = $0.350 billion b ($518 million in lease payments 77% operating) = $398.9 million = $0.399 billion c. Safeway’s adjusted ratio exceeds Albertson’s by 0.10. The adjustment doesn’t make much of a difference to Albertson’s since it does not have a significant lease liability. Although Safeway does have significant lease liabilities, the adjustment doesn’t make much of a difference to it since it already has a high ratio. d. An analyst may wish to make the adjustment required above so he/she can make equal comparisons between the large retailers. Safeway’s high ratio may have been attributable to capital leases recorded by Safeway. At the same time, Albertson’s ratio may not be as high if it had significant leases that it reported as operating leases. By making the adjustment, the analysts knows that differences due to accounting method choices or lease reporting choices have been removed. ID11–7 a. Weak economic news may cause a buying spree in the bond market because a weak economy often controls inflation, which increases the value of investments with a fixed rate of return. When the economy is weak, the Federal Reserve loosens the money supply so that inflation is not a threat. A looser money supply allows borrowing rates to fall. Since bond prices move in an opposite direction, bond prices increase. The result is a buying spree to beat bond price increases. With a strong bond market a company can sell bonds at a higher price and/or a lower rate of interest. b. Higher investor demand drives the price of bonds higher and the yield lower. The price of bonds and the yield move inversely to each other. The greater demand for bonds means that investors will have to be willing to accept a lower yield. The bond market is driven by supply versus demand and the greater the demand for bonds the higher the price, which means the lower the yield. c. There are many factors that impact the value of a company’s debt in the marketplace. The primary factors would be investors’ perception as to the company’s’ ability to repay the debt. Investors must assess the future earnings capability of the company to determine its creditworthiness. Another factor would be the terms of the debt, such as interest rate, call provisions, time to maturity, etc. ID11–8 a. The current debt covenant limits the company’s borrowing capacity by stating that tangible assets must be at least twice as great as senior indebtedness. The current calculation, based on the 2003 numbers, is $18,032/($18 + 242 + 5,114 + 1,986) = $18,032/$7,360 = 2.45 or 245%. If the company adds more debt, and purchases more tangible assets, with the proceeds of the debt, both the numerator and the denominator of the ratio will increase. To determine the maximum amount that could be added to both tangible assets and debt while still remaining in compliance with the covenant, the following calculation could be performed: 18,032 + X = 2 7,360 + X 1 where X is the amount of debt (and tangible assets) that could be added. Solving for X yields the result that $3,312 in debt could be added while still maintain compliance with the covenant. b. The creditors are trying to control the amount of debt that J.C. Penney has on its balance sheet by limiting that debt to a percentage of tangible assets of the company. Intangible assets such as goodwill or trademarks are not included in the ratio because the creditors, in a worst case scenario, fear that they would not be able to realize any value from the sale of those intangible assets. The tangible assets, including items such as inventory and PP&E, could more easily be sold to repay the debt provided by the creditors. c. If J.C. Penney violates the financial covenant, the creditors have the right to immediately call the loans, requiring the company to pay them off at once. Most likely, however, would be a renegotiation of the credit agreements between the creditors and the company. Contract issues such as interest rates, fees, and future financial covenants might be changed by the lenders who would feel that they are carrying more risk due to the covenant violation. ID11–9 a. On the financial statements a capital lease (a lease that is ―equivalent to purchasing an asset‖) is treated like the company had purchased the fixed asset. The asset and the related liability are recorded on the balance sheet and interest and depreciation are recorded on the income statement. An operating lease (a lease in the nature of short-term hire) is treated like a recurring expense each month but nothing is recorded on the balance sheet. The amount of the lease payment is shown as an expense each month. The result is that a company with an operating lease will show higher net income (in early years) and a lower debt/equity ratio than a company with a capital lease. ID11–9 Concluded b. The rule passed in 1981 was unpopular for 2 primary reasons. The first was that it forced to companies to capitalize some leases. This would have the impacts as described above. Capitalized leases would tend to lower net income and increase the debt/equity ratio. The second reason it was unpopular was because it was a relatively complex set of rules that had to be followed. These rules required a fair amount of time and effort for companies to implement. c. Financial engineers have sought to keep debt off the balance sheet by structuring contracts in such a manner that the contract will qualify as an operational lease when the reality is that the fixed asset has all other characteristics of an asset that would normally be capitalized. This is done by making sure that the lease contract does not meet any of the four criteria that would force the company to capitalize the lease. d. Mr. Holgate makes a good point. When two transactions, that are substantially the same, can be recorded in significantly different ways on the financial statements then there is a problem. This is confusing to users of the financial statements and can lead to non-productive decisions being made. Companies will structure transactions to work around accounting rules as opposed to structuring the transaction in the best way for the company. ID11–10 Bristol-Myers Squibb is concerned that changes in interest rates could adversely impact the company’s financial condition. To protect against this possibility—to manage its interest rate risk—the company has entered into interest rate swaps with another party. In essence, an interest rate swap allows the two parties to exchange interest payments. One party would have interest rates on debt that is locked in at a fixed rate, meaning that no matter what market rates of interest do, the fixed rate will not change. The other party to the swap agreement would have interest rates on debt that float with changes in market interest rates. The party with the fixed rate swaps interest payments with the party with floating rates, effectively giving the company the other rate arrangement. ID11–11 a. The long-term debt ratio/ total asset ratio for Home Depot was 7.2% in 2004 ($2,476/$34,437) and 7.2% in 2003 ($2,174/$30,011). The ratio did not change for Home Depot over this time period. b. Total interest costs as a percentage of revenues for 2004 was 0.10% ($62/$64,816), for 2003 was 0.06% ($37/$58,247), and for 2002 was 0.05% ($28/$53,553). While the ratio has increased slightly over the years, the interest expense is very low. c. The 2004 original cost of property under capital leases is $352. The straight-line method of depreciation is used for these assets. Footnote #5 indicates that total lease payments (both operating and capital) in 2004 will be $660 million, of which $608 million are for operating leases. Therefore, approximately 92% ($608/$660) of lease payments are for operating leases. d. In fiscall 2002 Home Depot received proceeds from long-term debt of $532 million, while in 2003 proceeds were only $1 million. In 2004, no proceeds were received from the issuance of long term debt. The company has become less reliant on long-term debt as a source of financing. e. The company has continued to grow (see Investing Activities on the Statement of Cash Flow), but as discussed in d. above, long term debt has not been the source of financing. The company, due to the strength of the stock market and the increased market price of its stock, has instead funded growth with issuances of equity. Also funding the growth, and reducing the reliance on long-term debt, has been the continued growth in cash generated from operations. f. Footnote #2 indicates that the market values of the Senior Notes are $515 million and $532 million, while the book value of the two debt issuances are $500 million each. This disparity is driven by the difference between the stated rate of interest on the Notes and the company’s effective interest rate as determined by the debt markets. g. Footnote #2 states that the Commercial Paper facility contains some ―restrictive‖ covenants, but details as to specific ratios are not given. The company does state that it feels the convenants will not have a material effect on the company. h. Footnote #1 describes the interest rate hedging instruments that the company uses to manage its interest rate exposure. Effectively Home Depot is able to swap fixed rates for variable rates in order to protect against fluctuations in the valuation of their obligations due to interest rate fluctuations in the marketplace.