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FSA CHAP 7

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FSA CHAP 7 Powered By Docstoc
					                                     Chapter 7
                            Long-Term Debt-Paying Ability

TO THE NET

1. a. SIC 7990 Services – Miscellaneous Amusement and Recreation

   b. Item 1 Business
      The Walt Disney Company, together with its subsidiaries, is a diversified
      worldwide entertainment company with operations in four business segments.

   c. There are legal proceedings relating to Walt Disney rights to use Winnie the
      Pooh. “Management believes that it is not currently possible to estimate the
      impact, if any, that the ultimate resolution of these matters will have on the
      Company’s results of operations, financial position or cash flows.”

   d. Changes in and Disagreements on Accounting and Financial Disclosure – None

   e. On May 5, 2006 (the closing date), the Company completed on all stock
      acquisition of Pixar.

   f. Executive compensation incorporated by reference in the proxy statement.

2. a. Net Periodic Cost (in millions)

           Pension Plans
               U.S.               $253
             Non-U.S.              151
           Other benefits          210
                                   614 (a)
             Net sales         $20,258 (b)
             (a) ÷ (b)          3.03%

      At 3.03%, net periodic cost does not appear to be material in relation to net
      sales.

      (Loss) income before income taxes and cumulative effect of accounting change
      is a loss of $224. Net periodic cost would appear to be material in relation to this
      number.




                                           185
b. Total benefit obligation at December 31, 2006 (in millions)

                         Pension Plans
                             U.S.               $5,417
                           Non-U.S.              2,999
                         Other benefits          2,478
                                               $10,894

      Total in plan assets at December 31, 2006 (in millions)

                          Pension Plans
                              U.S.              $4,050
                            Non-U.S.             1,922
                          Other benefits             4
                                                $5,976

      Total net funded status at December 31, 2006 (in millions)

                         Pension Plans
                             U.S.              $(1,367)
                           Non-U.S.             (1,077)
                         Other benefits         (2,474)
                                               $(4,918)

      Total net funded status at December 31, 2006            $4,918

      Total liabilities at December 31, 2006      $17,787

      Net funded status appears to be significant in relation to total liabilities.

   c. Total amounts recognized in the balance sheets at December 31, 2006 for
      pension and other post retirement benefits (in millions).

                    Pension Plans (in millions)

                    U.S.
                      Current Liabilities             $      (19)
                      Noncurrent liabilities              (1,348)
                    Non-U.S.
                      Current Liabilities                    (23)
                      Noncurrent liabilities              (1,089)
                    Other benefits
                      Current liabilities                 (231)
                      Noncurrent liabilities            (2,243)
                                                      $ (4,953)



                                            186
      Total liabilities at December 31, 2006     $17,787

      Amount recognized is significant in relation to total liabilities at December 31,
      2006.

      Net funded status at December 31, 2006          $(4,918)

      Amount recognized is significant in relation to net funded status at December 31,
      2006.

3. a. Times interest earned

      Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings,
      and Minority Earnings

      Interest Expense, Including Capitalized Interest

           December 30, 2006
        $123,439,000 + $4,923,000
              $4,923,000 + 0

                $128,362,000
                 $4,923,000

         26.07 times interest earned


   b. Debt ratio

        Total Liabilities
         Total Assets

        $185,242,000 + $79,126,000 + 73,489,000 + $5,870,000
                            $906,590,000

        $343,727,000
                            =   37.91%
        $906,590,000

   c. Operating cash flow / total debt

        $151,276,000
                            =   44.01%
        $343,727,000

   d. Times interest earned is very good
      Debt ratio appears to be reasonable
      Operating cash flow / total debt appears to be very good


                                           187
4. a. Times interest earned

      Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings,
      and Minority Earnings

         Interest Expense, Including Capitalized Interest
                           (in millions)

           2004                2005                  2006
       $355 + $107          $428 + $92            $377 + $78
         $107 + 0             $92 + 0               $78 + 0

           $462                 $520                $455
           $107                  $92                $78

       4.32 times             5.65 times           5.83 times


   b. Debt ratio

       Total Liabilities
        Total Assets

                             In Millions
                2005                            2006
        $1,899 + $1,480 + $71          $2,532 + $1,247 + $153
               $3,450                          $3,932
                 93.34%                            90.12%


   c. Operating cash flow / total debt

         2005                             2006
         $733                             $702
                   =   21.25%                      =   17.85%
        $3,450                           $3,932


   d. Times interest earned is improving and is likely adequate
      Debt ratio appears to be very high
      Operating cash flow / total debt decreased and is likely adequate




                                           188
QUESTIONS

7- 1.   Yes, profitability is important to a firm's long-term, debt- paying ability.
        Although the reported income does not agree with cash available in the short
        run, eventually the revenue and expense items do result in cash movements.
        Because there is a close relationship between the reported income and the
        ability of the entity to meet its long-run obligations, the major emphasis when
        determining the long-term, debt-paying ability is on the profitability of the
        entity.

7- 2.   (1) Income statement.

        (2) Balance sheet

        The income statement approach is important because in the long run, there is
        usually a relationship between the reported income that is the result of accrual
        accounting and the ability of the firm to meet its long-term obligations. The
        balance sheet indicates the amount of funds provided by outsiders in relation
        to those provided by owners of the firm. If a high proportion of the resources
        have been provided by outsiders, then this indicates that the risks of the
        business have been shifted to outsiders.

7- 3.   A relatively high, stable coverage of interest over the years is desirable. A
        relatively low, fluctuating coverage of interest over the years is not desirable.

7- 4.   No. The auto manufacturing business is known for its cyclical nature. The
        times interest expense, therefore, would fluctuate materially. We would expect
        the auto manufacturer to finance a relatively small proportion of its long-term
        funds from debt.

7- 5.   A telephone company has its rate of return and, therefore, profits controlled by
        public utility commissions. We would expect the times interest earned to be
        moderate and relatively stable, which should be a relatively favorable times
        interest earned ratio. This stability allows for carrying a high portion of debt
        financing.

7- 6.   A firm must pay for the interest capitalized; therefore, this interest should be
        included along with interest expense in order to obtain total interest.

7- 7.   To get a better indication of a firm's ability to cover interest payments in the
        short run, the non-cash charges for depreciation, depletion, and amortization
        can be added back to the times interest earned numerator. The resulting
        income can be related to interest earned on a cash basis for a short-run
        indication of the firm's ability to cover interest.




                                          189
7- 8.   The financial statements are predominately prepared based upon historical
        cost. Seldom is the market value or liquidation value disclosed.

7- 9.   No, the determination of the current value of the long-term assets is very
        subjective. The best that can be achieved is a reasonable relationship of
        long-term assets to long-term debt, based on historical cost or estimates of
        current value.

7-10.   The intent of this ratio is to indicate the percentage of the assets that were
        financed by creditors. The ratio should indicate a reasonably accurate picture
        of how the assets were financed, but it will not be precise because all of the
        liabilities have been included, while the assets are at book value, which may
        be less than or more than their liquidation value.

7-11.   No, the debt ratio would not be as high as the debt/equity ratio because the
        debt ratio relates total liabilities to total assets, while the debt/equity ratio
        relates total liabilities to shareholders' equity. The total asset figure is equal to
        both the liabilities and the shareholders' equity.

7-12.   The balance sheet equation has assets = liabilities + shareholders' equity.
        Given any set of figures that agree with the basic balance sheet equation, the
        liabilities are the same, whether they are related to assets or shareholders'
        equity.

        For example, assets ($100,000) = liabilities ($40,000) + shareholders' equity
        ($60,000).

                   Debt Ratio = $ 40,000 = 40%
                                $100,000

                   Debt / Equity Ratio = $ 40,000 = 66 2/3%
                                          $60,000


7-13.   Industry averages tend to indicate the degree of debt that is considered to be
        acceptable for an industry. The industry average does not necessarily indicate
        the degree of debt that an individual firm should have, but it is the best
        indication of a reasonable amount outside of the individual firm.

7-14.   Operating leases simply require recording rent expense in the income
        statement accounts. Under a capital lease, the asset and related lease
        obligations are recorded on the balance sheet of the lessee. The lessee then
        records depreciation expense and interest expense as would be done if the
        asset had been acquired with a loan.




                                            190
7-15.   If a firm has not capitalized its leases, then its debt ratios will be lower than
        those of a firm that has capitalized leases because the lease will not be
        included in assets and liabilities on the company’s balance sheet. Also, its
        times interest earned will be higher because interest expense is not included
        on the income statement, only rent expense. These two factors overstate the
        debt position.

7-16.   If leases are capitalized, then more interest expense must be covered. This
        causes a decline in times interest earned.

7-17.   Pension claims have the status of tax liens, which gives them senior claim
        over other creditors.

7-18.   When an employee is vested in the pension plan, she/he is eligible to receive
        some pension benefits at retirement regardless of whether they continue
        working for the employer. ERISA has had a major impact on reducing the
        vesting time.

7-19.   Under the Employee Retirement Income Security Act, a contributor to a
        multiemployer pension plan may be liable, upon withdrawal from or upon
        termination of such plan, for its share of any unfunded liability.

7-20.   An operating lease for a relatively long term is a type of long-term financing.
        Therefore, a part of the lease payment, in reality, is a financing charge called
        interest. When a portion of operating lease payments is included in fixed
        charges, it is an effort to recognize the true total interest that the firm is
        paying.

7-21.   The Employee Retirement Income Security Act contains a feature that a
        company can be liable for its pension plan up to 30% of its net worth. Also,
        the pension claims have the same status as tax liens, which gives them senior
        claim over other creditors.

7-22.   Short-term funds in total become part of the total sources of outside funds in
        the long run. Thus, short-term funds should be included in the debt ratio.
        Another view is that the debt ratio is intended to relate long-term outside
        sources of funds to total assets, and short-term funds are not a valid part of
        long-term funds. The approach that includes short-term liabilities is the more
        conservative.

7-23.   The bond payable account would represent a definite commitment that must
        be paid at some date in the future. This would be considered a firm liability.
        The reserve for rebuilding furnaces does not represent a firm commitment to
        pay out funds in the future. In addition, when the funds will be used for
        rebuilding furnaces is at the discretion of management. The reserve for
        rebuilding furnaces could be considered to be a soft liability account.



                                          191
7-24.   The specific assets that caused the deferred tax will likely be replaced by
        similar specific assets in the future, and also the firm may expand. The
        replacement assets are likely to cost more than the original items. This would
        result in an additional deferred tax. This is the total firm view of deferred taxes,
        and this view indicates that the deferred tax amount may not result in actual
        cash outlays in the future. In any specific year, there may be a cash outlay
        because the firm may not have acquired sufficient assets in that year in
        relation to the assets being expensed.

7-25.   This tentatively indicates that this firm has higher risk in terms of paying
        commitments than it did in prior periods and in relation to competitors and the
        industry.

7-26.   This would indicate an increase in risk as management will more frequently be
        faced with debt coming due. It also indicates that short-term debt is becoming
        a more permanent part of the financial structure of the firm.

7-27.   This statement would be correct. A note will disclose the guaranteed bank
        loan. The overall potential debt position will not be obvious from the face of
        the balance sheet.

7-28.   True. Significant potential liabilities may be described in the contingency note.
        If a contingency loss meets one, but not both, of the criteria for recording and,
        as a result, is not accrued, disclosure by note is made when it is at least
        reasonably possible that there has been an impairment of assets or that a
        liability has been incurred.

7-29.   Instead of having a potential additional liability from a pension plan, the plan
        may be overfunded. This may present an opportunity for the company to
        cancel the pension plan by paying off the pension obligations and transferring
        the remaining money in the pension plan to the company.

7-30.   Most firms must accrue or set a reserve for postretirement benefits other than
        pensions. Firms can usually spread the catch-up accrual costs over twenty
        years or take the charge in one lump sum. This choice can represent a major
        problem when comparing financial results of two or more firms.

7-31    Concentration of credit risk (lack of diversification) is perceived as indicative of
        greater credit risk. Disclosure in this area allows investors, creditors, and
        other users to make their own assessments of credit risk related to
        concentration.

7-32.   Off-balance-sheet means that the risk has not been recorded. There is a
        potential accounting loss from these obligations that is not apparent from the
        face of the balance sheet.



                                           192
7-33.   The disclosure of the fair value of financial instruments could possibly indicate
        significant opportunity or additional risk to the company.




                                          193
PROBLEMS

PROBLEM 7-1

                                     Recurring Earnings, Excluding Interest Expense, Tax
     Times Interest Earned       =    Expense, Equity Earnings, and Minority Earnings
                                       Interest Expense, Including Capitalized Interest

     Earnings before interest and tax:

Net
sale
s
 $
 1,079,143

Cost of sales

(792,755)

Selling and administration

(264,566)


$
21,822



                                     $21,822
a.   Times Interest Earned       =               =      5.06 times per year
                                      $4,311

b.   Cash basis times interest earned:

     $21,822 + $40,000           $61,822
                             =              =        14.34 times per year
          $4,311                  $4,311



PROBLEM 7-2

                                      Recurring Earnings, Excluding Interest Expense, Tax
a.   Times Interest Earned       =     Expense, Equity Earnings, and Minority Earnings
                                        Interest Expense, Including Capitalized Interest

     Income before income taxes          $ 675


                                               194
Plus interest                    60
Adjusted income               $ 735
Interest expense              $ 60

                            $735
Times interest earned   =          =     12.25 times per year
                             $60




                                   195
                                      Recurring Earnings, Excluding Interest Expense, Tax
                                       Expense, Equity Earnings, and Minority Earnings +
b.     Fixed Charge Coverage      =                 Interest Portion of Rentals
                                        Interest Expense, Including Capitalized Interest +
                                                    Interest Portion of Rentals

       Adjusted income from part (a)                    $ 735
       1/3 of operating lease payments (1/3 x $150)        50
       Adjusted income, including rentals               $ 785

       Interest expense                                 $  60
       1/3 of operating lease payments                     50
                                                        $ 110

                                      $785
       Fixed Charge Coverage      =           =    7.14 times per year
                                      $110


PROBLEM 7-3

                                      Recurring Earnings, Excluding Interest Expense, Tax
a.     Times Interest Earned      =    Expense, Equity Earnings, and Minority Earnings
                                        Interest Expense, Including Capitalized Interest

       Income before income taxes and extraordinary charges       $ 36
       Plus interest                                                16
       (1) Adjusted income                                          52
       (2) Interest expense                                       $ 16


     Times Interest Earned: (1) divided by (2) = 3.25 times per year




                                             196
                                         Recurring Earnings, Excluding Interest Expense, Tax
                                          Expense, Equity Earnings, and Minority Earnings +
b.   Fixed Charge Coverage          =                  Interest Portion of Rentals
                                           Interest Expense, Including Capitalized Interest +
                                                       Interest Portion of Rentals

     Adjusted income from part (a)                        $  52
     1/3 of operating lease payments (1/3 x $150)            50
     (1) Adjusted income, including rentals               $ 102

     Interest expense                                     $    16
     1/3 of operating lease payments                           50
     (2) Adjusted interest expense                        $    66


     Fixed charge coverage: (1) ÷ (2) = 1.55 times per year



PROBLEM 7-4


                         Total Liabilities            $174,979
a.   Debt Ratio     =                          =                    =   41.2%
                          Total Assets                $424,201

                                     Total Liabilities         $174,979
b.   Debt/Equity Ratio     =                              =                 =       70.2%
                                   Stockholders’ Equity        $249,222


c.   Ratio of Total Debt to Tangible Net Worth =

       Total Liabilities                 $174,979                $174,979
                               =                           =                    =    70.9%
     Tangible Net Worth              $249,222 – $2,324           $246,898


d. Kaufman Company has financed over 41% of its assets by the use of funds from
   outside creditors. The Debt/Equity Ratio and the Debt to Tangible Net Worth Ratio
   are over 70%. Whether these ratios are reasonable depends upon the stability of
   earnings.




                                                197
PROBLEM 7-5

                                               Times                                    Debt to
                                              Interest      Debt         Debt/Equity    Tangible
Transaction                                   Earned        Ratio          Ratio       Net Worth
a. Purchase of buildings financed by
    mortgage                                     -            +              +            +

b. Purchase of inventory on short-term
   loan at 1% over prime rate                    -            +              +            +

c.   Declaration and payment of cash
     dividend                                    0            +              +            +

d.   Declaration and payment of stock
     dividend                                    0            0              0            0

e.   Firm increases profits by cutting cost
     of sales                                    +             -              -            -

f.   Appropriation of retained earnings          0            0              0            0

g.   Sale of common stock                        0             -              -            -

h.   Repayment of long-term bank loan            +             -              -            -

i.   Conversion of bonds to common
     stock                                       +             -              -            -

j.   Sale of inventory at greater than cost      +             -              -            -



PROBLEM 7-6

a. Times Interest Earned:

     Times interest earned relates earnings before interest expense, tax, minority
     earnings, and equity income to interest expense. The higher this ratio, the better
     the interest coverage. The times interest earned has improved materially in
     strengthening the long-term debt position. Considering that the debt ratio and the
     debt to tangible net worth have remained fairly constant, the probable reason for
     the improvement is an increase in profits.

     The times interest earned only indicates the interest coverage. It is limited in that it
     does not consider other possible fixed charges, and it does not indicate the
     proportion of the firm’s resources that have come from debt.

     Debt Ratio:

     The debt ratio relates the total liabilities to the total assets.



                                                198
    The lower this ratio, the lower the proportion of assets that have been financed by
    creditors.

    For Arodex Company, this ratio has been steady for the past three years. This ratio
    indicates that about 40% of the total assets have been financed by creditors. For
    most firms, a 40% debt ratio would be considered to be reasonable.

    The debt ratio is limited in that it relates liabilities to the book value of total assets.
    Many assets would have a value greater than book value. This tends to overstate
    the debt ratio and, therefore, usually results in a conservative ratio. The debt ratio
    does not consider immediate profitability and, therefore, can be misleading as to
    the firm’s ability to handle long-term debt.

    Debt to Tangible Net Worth:

    The debt to tangible net worth relates total liabilities to shareholders' equity less
    intangible assets. The lower this ratio, the lower the proportion of tangible assets
    that has been financed by creditors.

    Arodex Company has had a stable ratio of approximately 81% for the past three
    years. This indicates that creditors have financed 81% as much as the
    shareholders after eliminating intangibles from the shareholders contribution – for
    most firms, this would be considered to be reasonable. The debt to tangible net
    worth ratio is more conservative than the debt ratio because of the elimination of
    intangible items. It is also conservative for the same reason that the debt ratio was
    conservative, in that book value is used for the assets and many assets have a
    value greater than book value. The debt to tangible net worth ratio also does not
    consider immediate profitability and, therefore, can be misleading as to the firm's
    ability to handle long-term debt.

    Collective inferences one may draw from the ratios of Arodex Company:
    Overall it appears that Arodex Company has a reasonable and improving long-term
    debt position. The debt ratio and the debt to tangible net worth ratios indicate that
    the proportion of debt appears to be reasonable. The times interest earned appears
    to be reasonable and improving.

    The stability of earnings and comparison with industry ratios will be important in
    reaching a conclusion on the long-term debt position of Arodex Company.

b. Ratios are based on past data. The future is what is important, and uncertainties of
   the future cannot be accurately determined by ratios based upon past data.

    Ratios provide only one aspect of a firm's long-term debt-paying ability. Other
    information, such as information about management and products, is also
    important.




                                              199
    A comparison of this firm's ratios with ratios of other firms in the same industry
    would be helpful in order to decide if the ratios are reasonable.


PROBLEM 7-7


                                      Recurring Earnings, Excluding Interest Expense, Tax
a. 1. Times Interest Earned      =     Expense, Equity Earnings, and Minority Earnings
                                        Interest Expense, Including Capitalized Interest

      $162,000
                  =   8.1 times per year
       $20,000

                      Total Liabilities
  2. Debt Ratio =
                       Total Assets


      $193,000
                  =   32.2%
      $600,000




                                            200
                                  Total Liabilities
  3. Debt/Equity Ratio     =
                                Stockholders’ Equity

      $193,000
                   =    47.4%
      $407,000

                                                     Total Liabilities
  4. Debt to Tangible Net Worth Ratio       =
                                                   Tangible Net Worth

           $193,000
                                =   49.9%
      $407,000 – $20,000


b. New asset structure for all plans:

  Assets
  Current Assets                        $ 226,000
  Property, plant and equipment           554,000
  Intangibles                              20,000
  Total assets                          $ 800,000


  Liabilities and Equity

  Plan A

  Current Liabilities               $ 93,000      $200,000,000/100 =
  Long-term debt                      100,000     2,000,000 shares
  Preferred stock                     250,000
  Common equity                       357,000     No change in net income
                                    $ 800,000

  Plan B

  Current Liabilities               $ 93,000      $200,000,000/10 =
  Long-term debt                      100,000     20,000,000 shares
  Preferred stock                      50,000
  Common stock                        120,000
  Premium on common stock             300,000
  Retained earnings                   137,000     No change in net income
                                    $ 800,000




                                            201
Plan C

  Current liabilities                $ 93,000        Operating income    $ 162,000
  Long-term debt                       300,000       Interest expense       52,000*
  Preferred stock                       50,000                           $ 110,000
  Common equity                        357,000       Taxes (40%)            44,000
                                     $ 800,000       Net income          $ 66,000

  *$20,000 + 16%($200,000) = $52,000

                                      Recurring Earnings, Excluding Interest Expense, Tax
  1. Times Interest Earned       =     Expense, Equity Earnings, and Minority Earnings
                                        Interest Expense, Including Capitalized Interest

              Plan A                          Plan B                     Plan C

     $162,000                         $162,000                     $162,000
              = 8.1 times                      = 8.1 times                  = 3.1 times
      $20,000                          $20,000                      $52,000


                        Total Liabilities
  2. Debt Ratio     =
                         Total Assets

              Plan A                          Plan B                     Plan C

     $193,000                         $193,000                     $393,000
              = 24.1%                          = 24.1%                      = 49.1%
     $800,000                         $800,000                     $800,000


                                 Total Liabilities
  3. Debt/Equity Ratio =
                               Stockholders’ Equity

              Plan A                          Plan B                     Plan C

     $193,000                         $193,000                     $393,000
              = 31.8%                          = 31.8%                      = 96.6%
     $607,000                         $607,000                      407,000


                                              Total Liabilities
  4. Debt to Tangible Net Worth        =
                                            Tangible Net Worth

           Plan A                                Plan B                           Plan C

     $193,000                             $193,000                        $393,000
                   = 32.9%                              = 32.9%                         = 101.6%
$607,000 – $20,000                   $607,000 – $20,000              $407,000 – $20,000




                                               202
c.   Preferred Stock Alternative:

     Advantages:
     1. Lesser drop in earnings per share than under the common stock alternative.

     2. Not the absolute reduction in earnings that accompanied the debt alternative.

     3. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and Total
        Debt to Tangible Net Worth Ratio.

     4. Does not have the reduced times interest earned that accompanied alternative
        of issuing long-term debt.

     Disadvantage:
     1. An increase in the fixed preferred dividend charge that the firm must pay before
         any dividends can be paid to common stockholders.


     Common Stock Alternative:

     Advantages:
     1. No increase in fixed obligations.

     2. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and the
        Total Debt to Tangible Net Worth Ratio.

     3. Not the absolute reduction in earnings that accompanied the debt alternative.

     4. Does not have the reduced times interest earned that accompanied alternative
        of issuing long-term debt.

     Disadvantage:
     1. Maximum dilution in earnings per share of the three alternatives.


     Long-Term Bonds Alternative:

     Advantage:
     1. Higher earnings per share than with common stock.

     Disadvantages:
     1. Material decline in Times Interest Earned.

     2. A material increase in the Debt Ratio, Debt/Equity Ratio, and Total Debt to
        Tangible Net Worth Ratio.




                                            203
     3. Absolute reduction in earnings.

     4. Increase in the interest fixed charge that must be paid.

d. The 10% preferred stock increased the preferred dividends which are not tax
   deductible; therefore, the cost of these funds is the 10% amount. The 16% bonds
   are tax deductible and, therefore, the after-tax cost is 9.6% [16% x (1-.40)].

     Note to Instructor: You may want to take this opportunity to point out to the students
     that the alternative that should be selected is greatly influenced by the change in
     earnings and the specific debt structure. The conclusions in this problem would not
     necessarily be true with changed assumptions.


PROBLEM 7-8

                                  Recurring Earnings, Excluding Interest Expense, Tax
a. Times Interest Earned      =    Expense, Equity Earnings, and Minority Earnings
                                    Interest Expense, Including Capitalized Interest


     Earnings from continuing operations before
     Income taxes and equity earnings                   $      74,780,000
     Add back interest expense                        (1)      37,646,000
     Adjusted earnings                                (2)     112,426,000


     Times interest earned: [(2) ÷ (1)] = 2.99 times per year

b.    Earnings from continuing operations                $     65,135,000
      Plus: Interest                                   (1)     37,646,000
           Income taxes                                        37,394,000
      Adjusted earnings                                (2)    140,175,000


     Times interest earned: [(2) ÷ (1)] 3.72 times per year

c.   Including equity earnings gives a less conservative times interest earned ratio. The
     equity income is usually substantially more than the cash dividend received from
     the related investments. Therefore, the firm cannot depend on this income to cover
     interest payments.




                                            204
PROBLEM 7-9                                Line up: Allen Co.              Baxter Co.

                                 Recurring Earnings, Excluding Interest Expense, Tax
a. 1. Times Interest Earned    =  Expense, Equity Earnings, and Minority Earnings
                                   Interest Expense, Including Capitalized Interest

         $95,000                         $170,000
                    =   9.5 times                    =   5.3 times
         $10,000                          $32,000


                    Total Liabilities   $160,000                 $575,000
  2. Debt Ratio =                     =             = 44.9%               = 58.4%
                     Total Assets       $356,000                 $985,000


                       Total Liabilities    $160,000                 $575,000
  3. Debt Equity =                        =          = 81.6%                  = 140.2%
                     Shareholders’ Equity   $196,000                 $410,000


  4. Debt to Tangible Net Worth =

              Total Liabilities                      $160,000
                                         =                           = 86.5%
      Shareholders’ Equity – Intangibles        $196,000 – $11,000

           $575,000
                              = 147.4%
      $410,000 – $20,000


b. No, Barker Company has a times interest earned of 5.3 times while the industry
   average is 7.2 times. This indicates that Barker Company has less than average
   coverage of its interest. Also, Barker Company has a much higher than average
   debt/equity ratio, and debt to tangible net worth ratio.

c. Allen Company has a better times interest earned, debt ratio, debt/equity ratio, and
   debt to tangible net worth.




                                          205
PROBLEM 7-10

                                Recurring Earnings, Excluding Interest Expense, Tax
a. 1.   Times Interest Earned =  Expense, Equity Earnings, and Minority Earnings
                                  Interest Expense, Including Capitalized Interest

                   $280,000 – $156,000
        2007:                                     = 7.29 times per year
                         $17,000

                   $302,000 – $157,000
        2006:                                     = 9.06 times per year
                         $16,000

                   $286,000 – $154,000
        2005:                                     = 8.80 times per year
                         $15,000

                   $270,000 – $150,000
        2004:                                     = 8.28 times per year
                         $14,500

                   $248,000 – $147,000
        2003:                                     = 4.39 times per year
                         $23,000


                                   Recurring Earnings, Excluding Interest Expense,
                                     Tax Expense, Equity Earnings, and Minority
   2. Fixed Charge Coverage =           Earnings + Interest Portion of Rentals
                                  Interest Expense, Including Capitalized Interest +
                                              Interest Portion of Rentals

                   $280,000 – $156,000 + $10,000
        2007:                                    = 4.96 times per year
                              $17,000

                   $302,000 – $157,000 + $9,000
        2006:                                      = 6.16 times per year
                             $16,000

                   $286,000 – $154,000 + $9,500
        2005:                                      = 5.78 times per year
                             $15,000

                   $270,000 – $150,000 + $10,000
        2004:                                    = 5.31 times per year
                              $14,500

                   $248,000 – $147,000 + $9,000
        2003:                                      = 3.44 times per year
                             $23,000




                                         206
                       Total Liabilities
3. Debt Ratio     =
                        Total Assets

                $88,000 + $170,000
   2007:                                     = 46.07%
                     $560,000

                $89,500 + $168,000
   2006:                                     = 46.48%
                     $554,000

                $90,500 + $165,000
   2005:                                     = 46.14%
                     $553,800

                $90,000 + $164,000
   2004:                                     = 46.31%
                     $548,500

                $91,500 + $262,000
   2003:                                     = 65.83%
                     $537,000



                               Total Liabilities
4. Debt/Equity Ratio    =
                             Shareholders’ Equity

                $88,000 + $170,000
   2007:                                     = 85.43%
                     $302,000

                $89,500 + $168,000
   2006:                                     = 86.85%
                     $296,500

                $90,500 + $165,000
   2005:                                     = 85.65%
                     $298,300

                $90,000 + $164,000
   2004:                                     = 86.25%
                     $294,500

                $91,500 + $262,000
   2003:                                     = 192.64%
                     $183,500




                                     207
                                                     Total Liabilities
   5. Debt to Tangible Net Worth      =
                                          Shareholders’ Equity – Intangible Assets

                    $88,000 + $170,000
       2007:                                        = 91.49%
                    $302,000 – $20,000

                    $89,500 + $168,000
       2006:                                        = 92.46%
                    $296,500 – $18,000

                    $90,500 + $165,000
       2005:                                        = 90.83%
                    $298,300 – $17,000

                    $90,000 + $164,000
       2004:                                        = 91.20%
                    $294,500 – $16,000

                    $91,500 + $262,000
       2003:                                        = 209.79%
                    $183,500 – $15,000


b. Both the times interest earned and the fixed charge coverage are good. The times
   interest earned is substantially better than the fixed charge coverage because of
   the operating leases. Both of these ratios materially declined in 2007.

   The debt ratio, debt/equity ratio, and debt to tangible net worth materially improved
   between 2003 and 2004 when long-term debt was reduced and funding shifted to
   equity. During the period 2004-2007, these ratios were relatively steady and
   appeared to be good. The debt to tangible net worth ratio is not as good as the
   debt/equity ratio because of the influence of intangibles.




                                          208
PROBLEM 7-11

a.   4   The times interest earned ratio indicates a firm’s long-term debt-paying ability
         from the income statement view.


b.   5   Preferred stock is owned by stockholders.

c.   5   The bonds payable liability will be shown on the balance sheet.

d.   5   The denominator of the debt ratio is total assets. Therefore, none of these
         assets are subtracted.

e.   5   The current ratio is considered to be a liquidity ratio.

f.   4   The debt/equity ratio represents a balance sheet view of debt.

g.   5   There is not adequate information to form an opinion on the long-term debt
         position.

h.   2   With a times interest earned ratio of .20 to 1, net income is less than the
         interest expense.

i.   5   Intangible assets are subtracted in the denominator. Land and bonds payable
         are not intangible assets.

j.   2   The ratio fixed charge coverage is an income statement indication of debt-
         paying ability.

k.   1   The Employee Retirement Income Security Act calls for a company to be
         liable for its pension plan up to 30 percent of its net worth.

l.   1   Capitalized interest should be included with interest expense when computing
         times interest earned.

m.   3   Minority shareholders’ interest does not represent a definite commitment to
         pay out funds in the future.




                                          209
   CASES

   CASE 7-1 EXPENSING INTEREST NOW AND LATER
   (This case provides an opportunity to review capitalized interest.)

   a.
                                           2006                  2005               2004
     Income statement interest expense $ 63,000,000          $ 54,000,000       $ 187,000,000
     Capitalized interest                118,000,000           111,000,000        316,000,000
     Total interest                    $ 181,000,000         $ 165,000,000      $ 503,000,000

   b.
                                              2006               2005                 2004
     Interest expense on income
     statement                            $ 63,000,000       $ 54,000,000       $ 187,000,000

   c.
                                              2006               2005                 2004
     Interest added to the cost of
     property, plant, and equipment       $ 118,000,000      $ 111,000,000      $ 316,000,000


   d. It is capitalized in fixed assets and becomes part of the depreciation expense when
      the fixed asset is depreciated.

   e. Since the interest is capitalized, the interest does not appear on the income
      statement until the asset depreciated.

                              Recurring Earnings, Excluding Interest Expense, Tax
   f. Times Interest Earned =  Expense, Equity Earnings, and Minority Earnings
                                Interest Expense, Including Capitalized Interest


            2006                            2005                               2004
$14,587,000,000 + $63,000,000   $13,116,000,000 + $54,000,000     $12,331,000,000 + $187,000,000
 $63,000,000 + $118,000,000      $54,000,000 + $111,000,000        $187,000,000 + $316,000,000

        $14,650,000,000                $13,170,000,000                    $12,518,000,000
         $181,000,000                   $165,000,000                       $503,000,000

          80.94 times                     79.82 times                        24.89 times

   The ratio trend is improving, 2004 had significant interest expense and a large amount
   of capitalized interest.




                                              210
CASE 7-2 CONSIDERATION OF LEASES
(This case provides the opportunity to review the influence of operating and capital
leases.)

a. 1. Times Interest Earned
                                            Shift over
         February 25, 2005               February 27, 2004
          5.0 + 20.9 + 8.2              (92.9) + 18.5 + 42.3
                20.9                            18.5
             1.63 times                       Negative

     2. Fixed Charge Coverage

         5.0 + 20.9 + 8.2 + 1/3(57.9)           (92.9) + 18.5 + 42.3 + 1/3(57.2)
               20.9 + 1/3 (57.9)                        18.5 + 1/3 (57.2)
                 1.33 times                                Negative

     3. Debt Ratio

          1,168.0         1,154.6
          2,364.6         2,359.4
          49.40%          48.94%

     4. Debt/Equity

          1,168.0         1,154.6
          1,196.6         1.204.8
          97.61%          95.83%

b. Debt ratio considering operating leases

       February 25, 2005            Delete
                                    lines
      1,168.0 + 2/3(291.2)
      2,364.6 + 2/3(291.2)

        1,168.0 + 194.1             1,362.1
                              =                =    53.23%
        2,364.6 + 194.1             2,558.7

     Note: Information not available to compute for February 27, 2006.

c.   For Steelcase, there was a moderate increase in the debt ratio when considering
     the operating leases.




                                              211
CASE 7-3 HOW MAY I HELP YOU?
(This case provides an opportunity to review an amortization vs. payments on leases)

a. The lease is a type of intangible. It is described as amortization if it is a periodic
   allocation of the cost of an intangible asset.

b.
     Assets                                                      2005           2004
     Property under capital lease:
     Property under capital lease                                $ 4,997        $ 4,286
     Less accumulated amortization                                 1,838          1,673
                                                                 $ 3,159        $ 2,613
     Liabilities
     Current liabilities:
     Obligations under capital leases due within one year        $ 210          $ 196
     Long-term liabilities:
     Long-term obligations under capital leases                    3,582          2,997
     Total related to capital leases                             $ 3,792        $ 3,193


The asset is being amortized while the liability goes down based upon payments.



CASE 7-4 LOCKOUT
(This case provides an opportunity to review an interesting commitments and
contingencies note of the Boston Celtics.)

The note must be subjectively incorporated into the analysis. This is part of the art of
analysis.

To quote from the note:

“Although the ultimate outcome of this matter cannot be determined at this time, any
loss of games as a result of the absence of a collective bargaining agreement or the
continuation of the lockout will have material advance effect on the Partnership’s
financial condition and its results of operations.”

In the long run, the lockout may be positive as aggregate salaries may be reduced.




                                            212
CASE 7-5 MANY EMPLOYERS

(This case provides an opportunity to review a multi-employer pension plan.)

a.
                                  2006                 2005             2004
     Contributions (a)        $253,800,000         $234,500,000     $196,800,000

     Material increase in contributions to multi-employer pension plans.

b.   “These plans are generally defined benefit plans; however, in many cases, specific
     benefit levels are not negotiated with or known by the employer – contributors.” …

c.   They have agreed with the unions to participate in various multi-employer
     retirement plans. They have no control over the payments.


CASE 7-6 POST RETIREMENT COMMITMENTS

(This case provides an opportunity to review a “Retirement Restoration Plan” and a
“Postretirement Benefits Other than Pensions”.)

a. 1. Retirement Restoration Plan

                                        2006              2005            2004
         Recognized expense          $5,200,000        $6,400,000      $7,100,000

     2. Postretirement Benefits Other than Pensions

                                        2006              2005           2004
         Benefit expense             $5,500,000        $4,200,000     $10,300,000

b. 1. Retirement Restoration Plan

                                                         2006             2005
         Aggregate projected benefit obligation       $57,000,000      $72,800,000

     2. Postretirement Benefit Other than Pensions

                                                         2006             2005
         Postretirement benefit obligation            $51,700,000      $50,300,000

c.   Apparently these plans are not funded.




                                             213
CASE 7-7 PLAY IT SAFE

(This case provides an opportunity to review defined benefit, non-contributory
retirement plans.)

a. Defined benefit, non-contributory retirement plans

                                      2006               2005                2004
     Pension expense (a)           $83,100,000       $115,600,000        $112,900,000
     Operating revenue (b)       $40,185,000,000    $38,416,000,000     $35,822,900,000
     (a) ÷ (b)                        .21%               .30%                .32%

     There was a material decline in pension expense in relation to operating revenue.

b. Defined benefit, non-contributory retirement plans

                                             2006              2005              2004
     Pension expense (a)                 $83,100,000       $115,600,000      $112,900,000
     Income before income taxes (b)     $1,240,000,000     $849,000,000      $793,900,000
     (a) ÷ (b)                              6.70%            13.62%            14.22%

     A material decline in pension expense in relation to income before income taxes.

c.   Defined benefit, non-contributory retirement plans

                                            2006                    2005
     Benefit obligations               $2,181,600,000          $2,110,100,000
     Fair value of plan assets         $2,214,700,000          $2,102,800,000
     Funded status                      $33,100,000             ($7,300,000)

     Considering the size of the benefit obligation, the funded status is good. A potential
     concern is that some plans are under funded.

d. No. Some plans are over funded, while other plans are under funded.

e. No.

                                                             2006                2005
     Net amount recognized in financial position (a)      $33,100,000       $179,400,000
     Total liabilities (b)                              $10,606,900,000    $10,837,200,000
     (a) ÷ (b)                                               .31%               1.66%




                                            214
CASE 7-8 PRINTERS
(This case provides an opportunity to review a defined contribution plan.)

a. Defined contribution plan

b.
                                             2006              2005             2004
     Matching contributions (a)            $249,000          $225,000         $201,000
     Income before income taxes (b)       $6,033,000         $329,000        $8,437,000
     (a) ÷ (b)                              4.13%             68.39%           2.38%

     Substantial fluctuations in the materiality when compared with income before
     income taxes.

     Net sales (c)                        $64,328,000      $51,091,000       $59,847,000
     (a) ÷ (c)                               .39%             .44%              .34%

     Matching contributions appear reasonable in relation to net sales.

c.   Control appears to be good.
     “We match employees contributions at a rate of 50% of employees’ contributions
     up to the first 6% of the employees’ compensation contributed to the 401(k) plan.




CASE 7-9 FAIR VALUE OF FINANCIAL INSTRUMENTS
(This case provides an opportunity to review fair value of financial instruments.)

2006
Material difference between carrying amount $7,556,000 and estimated fair value
$5,238,000 for subordinated notes payable, including current portion.

2005
Substantial difference between carrying amount $7,375,000 and estimated fair value
$7,926,000 for subordinated notes payable, including current portion.

Material difference between carrying amount $100,000,000 and estimated fair value
$199,000,000 for subordinated convertible debentures.




                                           215
CASE 7-10 EAT AT MY RESTAURANT – DEBT VIEW
(This case provides an opportunity to view the debt position of three restaurants.)

a. Yums Brands
   Times interest earned was down substantially in 2006. It appears to be adequate.

     Panera Bread (is this correct in text? See note)
     Very high times interest earned for both years.

   Starbucks
   Times interest earned was down materially in 2006. Times interest earned is very
good.

b. Panera Bread has a very high times interest earned. Times interest earned for
   Starbucks is very good. Yums Brands times interest earned is low compared with
   the other two firms.

c.   Yums Brands
     Fixed charge coverage declined substantially in 2006. It appears to be low.

     Panera Bread
     Fixed charge coverage decreased materially in 2006. It appears to be very good.

     Starbucks
     Fixed charged coverage declined moderately in 2006. It appears to be good.

d. Panera Bread has the best fixed charge coverage, followed by Starbucks, and then
   Yums Brands.

e. Each of these companies has substantial leases. This reduces their fixed charge
   coverage.

f.   This is just a matter of the computation. The debt ratio compares liabilities with
     total assets. The debt/equity ratio compares liabilities with equity.

g. Yums Brands has higher liabilities in relation to total assets than either Panera
   Bread or Starbucks. Yums Brands is followed by Starbucks, and then Panera
   Bread. Panera Bread’s debt ratio is substantially lower than the other companies.

h. Intangibles have been removed from equity.




                                            216
THOMSON ONE

1.   This Thomson One exercise provides for a comment on the trend in selected debt
     ratios for the Merck & Company.

2.   This Thomson One exercise provides for a comment on the trend in selected debt
     ratios for Anheuser-Busch and Molson Coors Brewing Company. It also provides
     for a comparison of the Anheuser-Busch debt ratios with Molson Coors Brewing
     Company debt ratios.

3.   This Thomson One exercise provides for a comment on the trend in selected debt
     ratios for Apple Computer and Hewlett-Packard. It also provides for a comparison
     of the trend in the debt ratios for these companies.




                                          217

				
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