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Chapter 9 - Long-Term Liabilities Chapter 9 Long-Term Liabilities REVIEW QUESTIONS Question 9-1 (LO 9-1) Capital structure is the mixture of liabilities and stockholders’ equity a business uses. Companies in the auto industry, like Ford, typically lean more toward liabilities for their financing, while companies in the computer industry, like Microsoft, use stockholders’ equity to a greater extent in financing their asset growth. Question 9-2 (LO 9-1) One of the primary reasons a company chooses to borrow money rather than issue additional stock relates to taxes. Interest expense incurred when borrowing money is tax deductible, while dividends paid to stockholders is not tax deductible. Therefore, debt can be a less costly form of financing. A second reason relates to control. If a company issues additional shares to investors, control in the company is shared with the new shareholders. If a company borrows funds, voting control in the company is retained. Question 9-3 (LO 9-1) Bond issue costs include underwriting services, legal, accounting, registration, and printing fees incurred to complete the bond issue. An underwriter is the investment house through which the bonds are sold like JPMorganChase, Citigroup, and Bank of America. Question 9-4 (LO 9-1) A company that borrows by issuing bonds is effectively by-passing the bank and borrowing directly from the investing public, usually at a lower interest rate than in a bank loan. However, issuing bonds entails significant bond issue costs that often exceed 5% of the amount borrowed. For smaller loans, the additional bond issue costs exceed the savings from a lower interest rate, making it more economical to borrow from a bank. For loans of $20 million or more, the interest rate savings often exceed the additional bond issuance costs, making a bond issue more attractive. Question 9-5 (LO 9-2) (a) Secured bonds are supported by assets pledged as collateral. Unsecured bonds, also referred to as debentures, are not backed by a specific asset. (b) Term bonds require payment of the full principal amount of the bond at a single maturity date. Serial bonds require payments in installments over a series of years. (c) Callable bonds allow the issuer to repay the bonds before their scheduled maturity date at a specified call price. Convertible bonds allow the investor to convert each bond into a specified number of shares of common stock. Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-1 Chapter 9 - Long-Term Liabilities Answers to Review Questions (continued) Question 9-6 (LO 9-2) Convertible bonds allow the investor to convert each bond into a specified number of shares of common stock. The investor benefits from the conversion feature if share prices rise above the fixed conversion rate. For instance, assume a $1,000 bond is convertible into 40 shares of common stock, when the stock is trading at $23 per share. If the stock rises above $25 ($1,000/40), the shareholder will benefit by converting the bond into 40 common shares of stock. The borrower also benefits. Convertible bonds sell at a higher price and require a lower interest rate than bonds without a conversion feature. Question 9-7 (LO 9-3) We calculate the issue price of a bond as the present value of the principal (the face amount on the bond due at maturity) plus the present value of the periodic interest payments. It is not solely the present value of the principal; rather it is the present value of the principal plus the present value of the interest payments. Question 9-8 (LO 9-3) (a) The face amount is the amount that will be repaid at maturity. The carrying value is the balance in the bonds payable account at any point in time. For example a $100,000 bond that issues for $93,205 has a face value of $100,000 and a carrying value of $93,205 on the date of issue. The carrying value will increase from $93,205 to $100,000 over the life of the bond issue. (b) The stated interest rate is the rate used to determine the periodic interest payments paid by the borrower. The market interest rate represents the true interest rate used by investors to value the bond issue. Question 9-9 (LO 9-3) The bonds issue at a discount when the stated interest rate is less than the market interest rate. The bonds are paying less than the going rate and, therefore, issue at a discount. Question 9-10 (LO 9-3) The bonds issue at a premium when the stated interest rate is more than the market interest rate. The bonds are paying more than the going rate and, therefore, issue at a premium. Question 9-11 (LO 9-3) The cash payment every six months is $15,000 ($500,000 x .06 x 6/12). There will be 40 interest payments over the 20 years – one every six months. Question 9-12 (LO 9-3) (a) $562,757 (b) $500,000 (c) $446,612 (Note: These answers are based on a calculator/excel. Answers using the present value tables may differ just a little due to rounding.) © The McGraw-Hill Companies, Inc., 2014 9-2 Financial Accounting Chapter 9 - Long-Term Liabilities Answers to Review Questions (continued) Question 9-13 (LO 9-4) If bonds issue at a discount, the carrying value of the bonds and interest expense will increase over time. Recall that interest expense is calculated as the carrying value of the bond times the market interest rate. As carrying value increases, interest expense also increases. Question 9-14 (LO 9-4) If bonds issue at a premium, the carrying value of the bonds and interest expense will decrease over time. Recall that interest expense is calculated as the carrying value of the bond times the market interest rate. As carrying value decreases, interest expense also decreases. Question 9-15 (LO 9-4) Cash paid is calculated as the face amount of the bonds times the stated interest rate. Interest expense is the carrying value times the market rate. The difference between interest expense and the cash paid increases the carrying value of the bonds. At the maturity date, the carrying value will equal the face amount. The amortization schedule is similar when bonds are issued at a premium, except that the difference between interest expense and the cash paid decreases, rather than increases, the carrying value of the bonds over time. Question 9-16 (LO 9-5) If interest rates decrease, a company may choose to buy back high interest rate bonds and reissue bonds at a lower interest rate. A company can help protect itself from decreases in interest rates by including a call feature allowing the company to repurchase bonds at a fixed price (like 2% over face amount). When interest rates decrease, companies with a call provision are more likely to repurchase higher-cost debt and then reissue debt at new lower interest rates. Another incentive to repay debt early is to improve the company's debt and profitability ratios. Repurchasing debt can improve debt ratios. It can also improve profitability. If interest rates increase, bond prices go down and a company repurchasing the lower priced debt can report a gain on the income statement. Question 9-17 (LO 9-5) A loss of $50,000 is recorded by the issuer retiring the bonds as follows: Bonds Payable Loss Cash (Retire bonds before maturity) Solutions Manual, Chapter 9 280,000 50,000 330,000 © The McGraw-Hill Companies, Inc., 2014 9-3 Chapter 9 - Long-Term Liabilities Answers to Review Questions (continued) Question 9-18 (LO 9-6) Both interest expense and the carrying value of the note decrease over time. Interest expense decreases with each installment payment. In each of the following periods, the amount that goes to interest expense becomes less and the amount that goes to decreasing the carrying value becomes more. Interest expense decreases over time because the carrying value decreases over time, and interest is a constant percentage of carrying value. Question 9-19 (LO 9-6) Operating leases are like rentals. Short-term car rentals and most apartment leases are operating leases. Capital leases occur when the person or firm making the payments essentially buys an asset and borrows the money through a lease to pay for the asset. Question 9-20 (LO 9-7) Additional debt increases risk. Failure to repay debt or the interest associated with the debt on a timely basis may result in default and perhaps even bankruptcy. Other things being equal, the higher the debt, the higher the risk of bankruptcy. Additional debt also offers potential rewards. If a company earns a return in excess of the cost of borrowing the funds, shareholders are provided with a total return greater than what could have been earned with equity funds alone. Unfortunately, borrowing is not always favorable. Sometimes the cost of borrowing the funds exceeds the returns they generate. © The McGraw-Hill Companies, Inc., 2014 9-4 Financial Accounting Chapter 9 - Long-Term Liabilities BRIEF EXERCISES Brief Exercise 9-1 (LO 9-2) 1. Convertible bonds sell at a higher price and require a lower interest rate than bonds without a conversion feature. 2. Investors in convertible bonds benefit if the market price of the common stock goes above $50 per share ($1,000/20 shares = $50 per share) assuming the current share, the convertible bondholder can trade his $1,000 bond for 20 shares of stock worth $60 per share (or $1,200). Prior to conversion the bondholder still receives interest on the convertible bond. Brief Exercise 9-2 (LO 9-3) If the market rate is 7%, the bonds will issue at $60,000 (face amount). Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $60,000 $2,100 = $60,000 x 7% x ½ year 3.5% = 7% / 2 semi-annual periods 20 = 10 years x 2 periods each year Calculator Output Issue price Solutions Manual, Chapter 9 PV $60,000 © The McGraw-Hill Companies, Inc., 2014 9-5 Chapter 9 - Long-Term Liabilities Brief Exercise 9-3 (LO 9-3) If the market rate is 8%, the bonds will issue at $54,812 (a discount). Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $60,000 $2,100 = $60,000 x 7% x ½ year 4% = 8% / 2 semi-annual periods 30 = 15 years x 2 periods each year Calculator Output Issue price PV $54,812 Brief Exercise 9-4 (LO 9-3) If the market rate is 6%, the bonds will issue at $66,934 (a premium). Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $60,000 $2,100 = $60,000 x 7% x ½ year 3% = 6% / 2 semi-annual periods 40 = 20 years x 2 periods each year Calculator Output Issue price © The McGraw-Hill Companies, Inc., 2014 9-6 PV $66,934 Financial Accounting Chapter 9 - Long-Term Liabilities Brief Exercise 9-5 (LO 9-4) 1. January 1, 2015 Cash Bonds Payable (Issue bonds at face amount) 2. June 30, 2015 Interest Expense Cash ($70,000 x 7% x ½) (Pay semiannual interest) 70,000 70,000 2,450 2,450 Brief Exercise 9-6 (LO 9-4) 1. January 1, 2015 Cash Bonds Payable (Issue bonds at a discount) 2. June 30, 2015 Interest Expense ($63,948 x 8% x ½) Bonds Payable (difference) Cash ($70,000 x 7% x ½) (Pay semiannual interest) Solutions Manual, Chapter 9 63,948 63,948 2,558 108 2,450 © The McGraw-Hill Companies, Inc., 2014 9-7 Chapter 9 - Long-Term Liabilities Brief Exercise 9-7 (LO 9-4) 1. January 1, 2015 Cash Bonds Payable (Issue bonds at a premium) 2. June 30, 2015 Interest Expense ($76,860 x 6% x ½) Bonds Payable (difference) Cash ($70,000 x 7% x ½) (Pay semiannual interest) 76,860 76,860 2,306 144 2,450 Brief Exercise 9-8 (LO 9-4) 1. January 1, 2015 Cash Bonds Payable (Issue bonds at face amount) 2. December 31, 2015 Interest Expense Cash ($70,000 x 7%) (Pay annual interest) © The McGraw-Hill Companies, Inc., 2014 9-8 70,000 70,000 4,900 4,900 Financial Accounting Chapter 9 - Long-Term Liabilities Brief Exercise 9-9 (LO 9-4) 1. January 1, 2015 Cash Bonds Payable (Issue bonds at a discount) 2. December 31, 2015 Interest Expense ($64,008 x 8%) Bonds Payable (difference) Cash ($70,000 x7% ) (Pay annual interest) 64,008 64,008 5,121 221 4,900 Brief Exercise 9-10 (LO 9-4) 1. January 1, 2015 Cash Bonds Payable (Issue bonds at a premium) 76,860 2. December 31, 2015 Interest Expense ($76,860 x 6%) Bonds Payable (difference) Cash ($70,000 x 7%) (Pay annual interest) 4,612 288 76,860 4,900 Brief Exercise 9-11 (LO 9-4) $2,653 ($88,443 x 6% x ½). Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-9 Chapter 9 - Long-Term Liabilities Brief Exercise 9-12 (LO 9-4) Interest expense for the year ended December 31, 2015 would be $2,765. Interest expense for the first six months ended June 30, 2015 is $2,075 ($82,985 x 5% x ½). Interest expense for the next six months ended December 31, 2015 is $2,082 ([$82,985 +2,075 – 1,800] x 5% x ½). Thus, the total interest expense for the year is $2,075 + $2,082 = $4,157. Brief Exercise 9-13 (LO 9-4) 1. Cash 63,948 Bonds Payable (Issue bonds at a discount) 2. Interest Expense Bonds Payable Cash (Pay semiannual interest) 63,948 2,558 108 2,450 3. Interest expense increases each period because the carrying value of the debt issued at a discount increases over time. © The McGraw-Hill Companies, Inc., 2014 9-10 Financial Accounting Chapter 9 - Long-Term Liabilities Brief Exercise 9-14 (LO 9-4) 1. Cash 76,860 Bonds Payable (Issue bonds at a premium) 2. Interest Expense Bonds Payable Cash (Pay semi-annual interest) 76,860 2,306 144 2,450 3. Interest expense decreases each period because the carrying value of the debt issued at a premium decreases over time. Brief Exercise 9-15 (LO 9-5) Bonds Payable Loss Cash (Retire bonds before maturity) 64,168 3,832 68,000 Brief Exercise 9-16 (LO 9-5) Bonds Payable Gain Cash (Retire bonds before maturity) Solutions Manual, Chapter 9 76,567 4,567 72,000 © The McGraw-Hill Companies, Inc., 2014 9-11 Chapter 9 - Long-Term Liabilities Brief Exercise 9-17 (LO 9-6) January 1, 2015 Equipment Notes Payable (Issue a note payable) January 31, 2015 Interest Expense ($30,000 x 5% x 1/12) Notes Payable (difference) Cash (monthly payment) (Pay monthly installment on note) © The McGraw-Hill Companies, Inc., 2014 9-12 30,000 30,000 125.00 441.14 566.14 Financial Accounting Chapter 9 - Long-Term Liabilities Brief Exercise 9-18 (LO 9-7) 1. Total Liabilities $628 ÷ ÷ Equity $99 = = Debt to Equity Ratio 6.34 Average Total Assets $722.5* = = Return on Assets Ratio 9.1% 2. Net Income ÷ $66 ÷ *($718 + $727) / 2 3. Net Income $66 *($99 + $188) / 2 ÷ ÷ Average Stock Equity $143.5* = = Return on Equity Ratio 46.0% = = Times Interest Earned Ratio 8.3 4. Net Income + Interest + Taxes ÷ $125 ÷ Interest $15 The return on equity is higher than the return on assets, because the return on equity Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-13 Chapter 9 - Long-Term Liabilities EXERCISES Exercise 9-1 (LO 9-1) Requirement 1 Operating income Interest expense (bonds only) Income before tax Income tax expense (35%) Net income # of shares Earnings per share (Net income / # of shares) Issue Bonds $11,000,000 2,450,000 8,550,000 2,992,500 $ 5,557,500 Issue Stock $11,000,000 4,000,000 5,000,000 $1.39 $1.43 11,000,000 3,850,000 $ 7,150,000 Requirement 2 Issuing stock results in higher earnings per share. Issuing bonds results in earnings per share of $1.39 compared with $1.43 for issuing stock. © The McGraw-Hill Companies, Inc., 2014 9-14 Financial Accounting Chapter 9 - Long-Term Liabilities Exercise 9-2 (LO 9-2) Terms __e___ 1. Sinking fund. __g___ 2. Secured bond. __c___ 3. Unsecured bond. __f___ 4. Term bond. __b___ 5. Serial bond. __a___ 6. Callable bond. __d___ 7. Convertible bond. __h___ 8. Bond issue costs. Definitions a. Allows the issuer to pay off the bonds early at a fixed price. b. Matures in installments. c. Secure d. Allows the investor to transfer each bond into shares of common stock. e. Money set aside to pay debts as they come due. f. Matures on a single date. g. Supported by specific assets pledged as collateral by the issuer. h. Includes underwriting, legal, accounting, registration, and printing fees. Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-15 Chapter 9 - Long-Term Liabilities Exercise 9-3 (LO 9-3) Requirement 1 Premium. The issue price is $45,057,519 Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $41,000,000 $1,845,000 = $41,000,000 x 9% x ½ year 4% = 8% / 2 semi-annual periods 40 = 20 years x 2 periods each year Calculator Output Issue price PV $45,057,519 Requirement 2 Face amount. The issue price is $41,000,000. Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $41,000,000 $1,845,000 = $41,000,000 x 9% x ½ year 4.5% = 9% / 2 semi-annual periods 40 = 20 years x 2 periods each year Calculator Output Issue price © The McGraw-Hill Companies, Inc., 2014 9-16 PV $41,000,000 Financial Accounting Chapter 9 - Long-Term Liabilities Requirement 3 Discount. The issue price is $37,482,387 Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $41,000,000 $1,845,000 = $41,000,000 x 9% x ½ year 5% = 10% / 2 semi-annual periods 40 = 20 years x 2 periods each year Calculator Output Issue price Solutions Manual, Chapter 9 PV $37,482,387 © The McGraw-Hill Companies, Inc., 2014 9-17 Chapter 9 - Long-Term Liabilities Exercise 9-4 (LO 9-3) Requirement 1 Premium. The issue price is $27,934,072. Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $26,000,000 $910,000 = $26,000,000 x7% x ½ year 3% = 6% / 2 semi-annual periods 20 = 10 years x 2 periods each year Calculator Output Issue price PV $27,934,072 Requirement 2 Face amount. The issue price is $26,000,000. Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $26,000,000 $910,000 = $26,000,000 x 7% x ½ year 3.5% = 7% / 2 semi-annual periods 20 = 10 years x 2 periods each year Calculator Output Issue price © The McGraw-Hill Companies, Inc., 2014 9-18 PV $26,000,000 Financial Accounting Chapter 9 - Long-Term Liabilities Requirement 3 Discount. The issue price is $24,233,258. Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $26,000,000 $910,000 = $26,000,000 x 7% x ½ year 4% = 8% / 2 semi-annual periods 20 = 10 years x 2 periods each year Calculator Output Issue price PV $24,233,258 Exercise 9-5 (LO 9-4) January 1, 2015 Cash Bonds Payable (Issue bonds at face amount) June 30, 2015 Interest Expense Cash ($500,000 x 9% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense Cash ($500,000 x 9% x ½) (Pay semiannual interest) Solutions Manual, Chapter 9 500,000 500,000 22,500 22,500 22,500 22,500 © The McGraw-Hill Companies, Inc., 2014 9-19 Chapter 9 - Long-Term Liabilities Exercise 9-6 (LO 9-4) Requirement 1 (1) Date 1/ 1 /15 6/30/15 12/31/15 (2) (3) Cash Paid Face Amount x 4.5% Stated Rate Interest Expense Carrying Value x 5% Market Rate $ 22,500 22,500 Requirement 2 January 1, 2015 Cash Bonds Payable (Issue bonds at a discount) June 30, 2015 Interest Expense Bonds Payable (difference) Cash ($500,000 x 9% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense Bonds Payable (difference) Cash ($500,000 x 9% x ½) (Pay semiannual interest) © The McGraw-Hill Companies, Inc., 2014 9-20 (4) Increase in Carrying Value (3) $ 22,855 22,873 (2) $ 355 373 (5) Carrying Value Prior Carrying Value + (4) $ 457,102 457,457 457,830 457,102 457,102 22,855 355 22,500 22,873 373 22,500 Financial Accounting Chapter 9 - Long-Term Liabilities Exercise 9-7 (LO 9-4) Requirement 1 (1) Date (2) (3) Cash Paid Face Amount x 4.5% Stated Rate Interest Expense Carrying Value x 4% Market Rate 1/ 1 /15 6/30/15 12/31/15 $ 22,500 22,500 Requirement 2 January 1, 2015 Cash Bonds Payable (Issue bonds at a premium) June 30, 2015 Interest Expense Bonds Payable (difference) Cash ($500,000 x 9% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense Bonds Payable (difference) Cash ($500,000 x 9% x ½) (Pay semiannual interest) Solutions Manual, Chapter 9 (4) Decrease in Carrying Value (2) $ 21,979 21,958 (3) (5) Carrying Value Prior Carrying Value (4) $ 521 542 $ 549,482 548,961 548,419 549,482 549,482 21,979 521 22,500 21,958 542 22,500 © The McGraw-Hill Companies, Inc., 2014 9-21 Chapter 9 - Long-Term Liabilities Exercise 9-8 (LO 9-4) January 1, 2015 Cash Bonds Payable (Issue bonds at face amount) June 30, 2015 Interest Expense Cash ($600,000 x 7% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense Cash ($600,000 x 7% x ½) (Pay semiannual interest) © The McGraw-Hill Companies, Inc., 2014 9-22 600,000 600,000 21,000 21,000 21,000 21,000 Financial Accounting Chapter 9 - Long-Term Liabilities Exercise 9-9 (LO 9-4) Requirement 1 (1) Date (2) (3) Cash Paid Face Amount x 3.5% Stated Rate Interest Expense Carrying Value x 4% Market Rate 1/ 1 /15 6/30/15 12/31/15 $ 21,000 21,000 Requirement 2 January 1, 2015 Cash Bonds Payable (Issue bonds at a discount) June 30, 2015 Interest Expense Bonds Payable (difference) Cash ($600,000 x7% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense Bonds Payable (difference) Cash ($600,000 x 7% x ½) (Pay semiannual interest) Solutions Manual, Chapter 9 (4) Increase in Carrying Value (3) $ 22,369 22,424 (2) (5) Carrying Value Prior Carrying Value + (4) $ 1,369 1,424 $ 559,229 560,598 562,022 559,229 559,229 22,369 1,369 21,000 22,424 1,424 21,000 © The McGraw-Hill Companies, Inc., 2014 9-23 Chapter 9 - Long-Term Liabilities Exercise 9-10 (LO 9-4) Requirement 1 (1) Date 1/ 1 /15 6/30/15 12/31/15 (2) (3) Cash Paid Face Amount x 3.5% Stated Rate Interest Expense Carrying Value x 3% Market Rate $ 21,000 21,000 Requirement 2 January 1, 2015 Cash Bonds Payable (Issue bonds at a premium) June 30, 2015 Interest Expense Bonds Payable (difference) Cash ($600,000 x 7% x ½) (Pay semi-annual interest) December 31, 2015 Interest Expense Bonds Payable (difference) Cash ($600,000 x 7% x ½) (Pay semi-annual interest) © The McGraw-Hill Companies, Inc., 2014 9-24 (4) Decrease in Carrying Value (2) $ 19,339 19,289 (3) (5) Carrying Value Prior Carrying Value (4) $ 1,661 1,711 $ 644,632 642,971 641,260 644,632 644,632 19,339 1,661 21,000 19,289 1,711 21,000 Financial Accounting Chapter 9 - Long-Term Liabilities Exercise 9-11 (LO 9-4) January 1, 2015 Cash Bonds Payable (Issue bonds at face amount) December 31, 2015 Interest Expense Cash ($600,000 x 7%) (Pay annual interest) December 31, 2016 Interest Expense Cash ($600,000 x 7%) (Pay annual interest) Solutions Manual, Chapter 9 600,000 600,000 42,000 42,000 42,000 42,000 © The McGraw-Hill Companies, Inc., 2014 9-25 Chapter 9 - Long-Term Liabilities Exercise 9-12 (LO 9-4) Requirement 1 (1) Date 1/ 1 /15 12/31/15 12/31/16 (2) (3) Cash Paid Face Amount x 7% Stated Rate Interest Expense Carrying Value x 8% Market Rate $ 42,000 42,000 Requirement 2 January 1, 2015 Cash Bonds Payable (Issue bonds at a discount) December 31, 2015 Interest Expense Bonds Payable (difference) Cash ($600,000 x 7%) (Pay annual interest) December 31, 2016 Interest Expense Bonds Payable (difference) Cash ($600,000 x 7%) (Pay annual interest) © The McGraw-Hill Companies, Inc., 2014 9-26 (4) Increase in Carrying Value (3) $ 44,779 45,002 (2) (5) Carrying Value Prior Carrying Value + (4) $ 2,779 3,002 $ 559,740 562,519 565,521 559,740 559,740 44,779 2,779 42,000 45,002 3,002 42,000 Financial Accounting Chapter 9 - Long-Term Liabilities Exercise 9-13 (LO 9-4) Requirement 1 (1) Date (2) (3) Cash Paid Face Amount x 7% Stated Rate Interest Expense Carrying Value x 6% Market Rate 1/ 1 /15 12/31/15 12/31/16 $ 42,000 42,000 Requirement 2 January 1, 2015 Cash Bonds Payable (Issue bonds at a premium) December 31, 2015 Interest Expense Bonds Payable (difference) Cash ($600,000 x 7%) (Pay annual interest) December 31, 2016 Interest Expense Bonds Payable (difference) Cash ($600,000 x 7%) (Pay annual interest) Solutions Manual, Chapter 9 (4) Decrease in Carrying Value (2) $ 38,650 38,449 (3) (5) Carrying Value Prior Carrying Value (4) $ 3,350 3,551 $ 644,161 640,811 637,260 644,161 644,161 38,650 3,350 42,000 38,449 3,551 42,000 © The McGraw-Hill Companies, Inc., 2014 9-27 Chapter 9 - Long-Term Liabilities Exercise 9-14 (LO 9-5) Requirement 1 (1) Date (2) (3) Cash Paid Face Amount x 4.5% Stated Rate Interest Expense Carrying Value x 5% Market Rate 1/ 1 /15 6/30/15 12/31/15 6/30/16 12/31/16 $ 22,500 22,500 22,500 22,500 (4) Increase in Carrying Value (3) $ 22,855 22,873 22,892 22,911 (2) (5) Carrying Value Prior Carrying Value + (4) $ 355 373 392 411 $ 457,102 457,457 457,830 458,222 458,633 Requirement 2 If the market rate drops to 7%, it will cost $601,452 to retire the bonds. Calculator Input Bond characteristics Key 1. Face amount 2. Interest payment each period 3. Market interest rate each period 4. Periods to maturity Amount FV PMT I N $500,000 $22,500 = $500,000 x 9% x ½ year 3.5% = 7% / 2 semi-annual periods 36 = 18 years x 2 periods each year Calculator Output Issue price PV $601,452 December 31, 2016 Bonds Payable Loss Cash (Retire bonds before maturity) © The McGraw-Hill Companies, Inc., 2014 9-28 458,633 142,819 601,452 Financial Accounting Chapter 9 - Long-Term Liabilities Exercise 9-15 (LO 9-5) Requirement 1 (1) Date (2) (3) Cash Paid Face Amount x 3.5% Stated Rate Interest Expense Carrying Value x 3% Market Rate 1/ 1 /15 6/30/15 12/31/15 6/30/16 12/31/16 6/30/17 12/31/17 $ 21,000 21,000 21,000 21,000 21,000 21,000 (4) Decrease in Carrying Value (2) $ 19,339 19,289 19,238 19,185 19,130 19,074 (3) (5) Carrying Value Prior Carrying Value (4) $ 1,661 1,711 1,762 1,815 1,870 1,926 $ 644,632 642,971 641,260 639,498 637,683 635,813 633,887 Requirement 2 If the market rate increases to 8%, it will cost $568,311 to retire the bonds. Calculator Input Bond Characteristics Key 1. Face amount 2. Interest payment each period 3. Market interest rate each period 4. Periods to maturity Amount FV PMT I N $600,000 $21,000 = $600,000 x 7% x ½ year 4% = 8% / 2 semi-annual periods 14 = 7 years x 2 periods each year Calculator Output Issue price PV $568,311 December 31, 2017 Bonds Payable Gain Cash (Retire bonds before maturity) Solutions Manual, Chapter 9 633,887 65,576 568,311 © The McGraw-Hill Companies, Inc., 2014 9-29 Chapter 9 - Long-Term Liabilities Exercise 9-16 (LO 9-6) January 1, 2015 Cash Notes Payable (Issue a note payable) January 31, 2015 Interest Expense ($50,000 x 6% x 1/12) Notes Payable (difference) Cash (monthly payment) (Pay monthly installment on note) February 28, 2015 Interest Expense ([$50,000-578.64] x 6% x 1/12) Notes Payable (difference) Cash (monthly payment) (Pay monthly installment on note) © The McGraw-Hill Companies, Inc., 2014 9-30 50,000 50,000 250.00 578.64 828.64 247.11 581.53 828.64 Financial Accounting Chapter 9 - Long-Term Liabilities Exercise 9-17 (LO 9-6) Requirement 1 Assets $25 million = Liabilities $15 million + Equity ? - $15 million). Requirement 2 Total Liabilities $15 million Requirement 3 Total Liabilities $15 + $2 = $17 million ÷ ÷ ÷ ÷ Equity $10 million Stockho Equity $10 million = = Debt to Equity Ratio 1.50 = Debt to Equity Ratio = 1.70 Requirement 4 Under an operating lease, Coney Island reports a more favorable (lower) debt to equity ratio. Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-31 Chapter 9 - Long-Term Liabilities Exercise 9-18 (LO 9-7) Requirement 1 ($ in thousands) Total Liabilities ÷ Equity = Debt to Equity Ratio E-Travel Pricecheck $4,254,475 $486,610 ÷ ÷ $3,182,681 $1,607,614 = = 1.34 0.30 E-Travel has a higher debt to equity ratio than Pricecheck. The soft drink industry represented by Coca-Cola and Pepsi has a higher average debt to equity ratio than the travel industry represented by E-Travel and Pricecheck. Requirement 2 Net Income + ($ in thousands) Interest + Taxes ÷ Interest = Times Interest Earned Ratio E-Travel Pricecheck $94,233 $34,084 = = 6.2 17.6 $588,159 $600,724 ÷ ÷ Pricecheck, with a times interest earned ratio of 17.6, is better able to meet interest payments as they become due than E-Travel with a ratio of only 6.2. The soft drink industry represented by Coca-Cola and Pepsi has a higher average times interest earned ratio. © The McGraw-Hill Companies, Inc., 2014 9-32 Financial Accounting Chapter 9 - Long-Term Liabilities PROBLEMS: SET A Problem 9-1A (LO 9-3, 9-4) Requirement 1 Face amount. The issue price is $1,300,000. Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $1,300,000 $45,500 = $1,300,000 x 7% x ½ year 3.5% = 7% / 2 semi-annual periods 30 = 15 years x 2 periods each year Calculator Output Issue price PV (1) Date $1,300,000 (2) (3) Cash Paid Face Amount x 3.5% Stated Rate Interest Expense Carrying Value x 3.5% Market Rate 1/ 1 /15 6/30/15 12/31/15 Solutions Manual, Chapter 9 $ 45,500 45,500 $ 45,500 45,500 (4) Increase in Carrying Value (3) (2) $0 0 (5) Carrying Value Prior Carrying Value + (4) $ 1,300,000 1,300,000 1,300,000 © The McGraw-Hill Companies, Inc., 2014 9-33 Chapter 9 - Long-Term Liabilities Requirement 2 Discount. The issue price is $1,187,602. Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $1,300,000 $45,500 = $1,300,000 x 7% x ½ year 4% = 8% / 2 semi-annual periods 30 = 15 years x 2 periods each year Calculator Output Issue price (1) Date 1/ 1 /15 6/30/15 12/31/15 PV $1,187,602 (2) (3) Cash Paid Face Amount x 3.5% Stated Rate Interest Expense Carrying Value x 4% Market Rate $ 45,500 45,500 © The McGraw-Hill Companies, Inc., 2014 9-34 $ 47,504 47,584 (4) Increase in Carrying Value (3) (2) $ 2,004 2,084 (5) Carrying Value Prior Carrying Value + (4) $ 1,187,602 1,189,606 1,191,690 Financial Accounting Chapter 9 - Long-Term Liabilities Requirement 3 Premium. The issue price is $1,427,403. Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $1,300,000 $45,500 = $1,300,000 x 7% x ½ year 3% = 6% / 2 semi-annual periods 30 = 15 years x 2 periods each year Calculator Output Issue price PV (1) Date $1,427,403 (2) (3) Cash Paid Face Amount x 3.5% Stated Rate Interest Expense Carrying Value x 3% Market Rate 1/ 1 /15 6/30/15 12/31/15 Solutions Manual, Chapter 9 $ 45,500 45,500 $ 42,822 42,742 (4) Decrease in Carrying Value (2) (3) $ 2,678 2,758 (5) Carrying Value Prior Carrying Value (4) $ 1,427,403 1,424,725 1,421,967 © The McGraw-Hill Companies, Inc., 2014 9-35 Chapter 9 - Long-Term Liabilities Problem 9-2A (LO 9-4) Requirement 1 January 1, 2015 Cash Bonds Payable (Issue bonds at face amount) June 30, 2015 Interest Expense Cash ($600,000 x 8% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense Cash ($600,000 x 8% x ½) (Pay semiannual interest) Requirement 2 January 1, 2015 Cash Bonds Payable (Issue bonds at a discount) June 30, 2015 Interest Expense ($544,795 x 9% x ½) Bonds Payable (difference) Cash ($600,000 x 8% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense ([$544,795+$516] x 9% x ½) Bonds Payable (difference) Cash ($600,000 x 8% x ½) (Pay semiannual interest) © The McGraw-Hill Companies, Inc., 2014 9-36 600,000 600,000 24,000 24,000 24,000 24,000 544,795 544,795 24,516 516 24,000 24,539 539 24,000 Financial Accounting Chapter 9 - Long-Term Liabilities Requirement 3 January 1, 2015 Cash Bonds Payable (Issue bonds at a premium) June 30, 2015 Interest Expense (664,065 x 7% x ½) Bonds Payable (difference) Cash ($600,000 x 8% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense ([$664,065 $758] x 7% x ½) Bonds Payable (difference) Cash ($600,000 x 8% x ½) (Pay semiannual interest) Solutions Manual, Chapter 9 664,065 664,065 23,242 758 24,000 23,216 784 24,000 © The McGraw-Hill Companies, Inc., 2014 9-37 Chapter 9 - Long-Term Liabilities Problem 9-3A (LO 9-4) 1. 2. 3. 4. 5. 6. Discount $37,281,935 $40,000,000 7% ($1,400,000 cash paid ÷ $40,000,000 face value) x 2 8% ($1,491,277 interest expense ÷ $37,281,935 carrying value) x 2 $28,000,000 ($1,400,000 x 20 payments) © The McGraw-Hill Companies, Inc., 2014 9-38 Financial Accounting Chapter 9 - Long-Term Liabilities Problem 9-4A (LO 9-4) Requirement 1 (1) Date (2) (3) Cash Paid Face Amount x 4% Stated Rate Interest Expense Carrying Value x 4.5% Market Rate 1/ 1 /15 6/30/15 12/31/15 $ 36,000 36,000 Requirement 2 January 1, 2015 Cash Bonds Payable (Issue bonds at a discount) Requirement 3 June 30, 2015 Interest Expense ($841,464 x 9% x ½) Bonds Payable (difference) Cash ($900,000 x 8% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense ($843,330 x 9% x ½) Bonds Payable (difference) Cash ($900,000 x 8% x ½) (Pay semiannual interest) Solutions Manual, Chapter 9 $ 37,866 37,950 (4) Increase in Carrying Value (3) (2) (5) Carrying Value Prior Carrying Value + (4) $ 1,866 1,950 $ 841,464 843,330 845,280 841,464 841,464 37,866 1,866 36,000 37,950 1,950 36,000 © The McGraw-Hill Companies, Inc., 2014 9-39 Chapter 9 - Long-Term Liabilities Problem 9-5A (LO 9-6) Requirement 1 January 1, 2015 Building Cash Notes Payable (Issue a mortgage note payable) Requirement 2 (1) (2) Date 1/1/15 1/31/15 2/28/15 360,000 60,000 300,000 (3) (4) (5) Cash Paid Interest Expense Decrease in Carrying Value Carrying Value Monthly Payment Carrying Value x 0.07 x 1/12 $3,483.25 3,483.25 $ 1,750.00 1,739.89 Requirement 3 January 31, 2015 Interest Expense ($300,000 x 7% x 1/12) Notes Payable (difference) Cash (monthly payment) (Pay monthly installment on note ) (2) (3) $ 1,733.25 1,743.36 Prior Carrying Value (4) $ 300,000.00 298,266.75 296,523.39 1,750.00 1,733.25 3,483.25 In the first monthly payment, $1,750.00 goes to interest expense and $1,733.25 goes to reducing the carrying value of the loan. Requirement 4 Total payments on the loan are $417,990. Since actual payments on the loan are $300,000, the remainder of $117,990 is the amount paid for interest expense. Problem 9-6A (LO 9-6, 9-7) Requirement 1 © The McGraw-Hill Companies, Inc., 2014 9-40 Financial Accounting Chapter 9 - Long-Term Liabilities Assets $81 million = Liabilities $11 + $41 = $52 million + Equity ? 29 million ($81 million - $52 million). Requirement 2 Total Liabilities $52 million ÷ ÷ Equity $29 million = = Debt to Equity Ratio 1.79 Requirement 3 An operating lease is like a rental. Over the lease term, the company making the lease payments records rent expense and the company receiving the rent payments records rent revenue. A capital lease is different. In a capital lease, the company making lease payments (called the lessee) essentially buys the asset and borrows the money through a lease to pay for the asset. The lease is recorded as an asset and a liability on Requirement 4 Yes. The debt to equity ratio will not be affected under an operating lease. However, under a capital lease, assets and liabilities will both increase $16 million while the debt to equity ratio. Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-41 Chapter 9 - Long-Term Liabilities Requirement 5 The debt to equity ratio will not be in violation (exceed 2.0) under an operating lease, but will be in violation (exceed 2.0) under a capital lease. Therefore, Thrillville has a strong incentive to structure the lease agreement as an operating lease. Operating lease: Total Liabilities $52 million ÷ ÷ Equity $29 million = = Debt to Equity Ratio 1.79 = = Debt to Equity Ratio 2.34 Capital lease: Total Liabilities $68 million ÷ ÷ Equity $29 million © The McGraw-Hill Companies, Inc., 2014 9-42 Financial Accounting Chapter 9 - Long-Term Liabilities Problem 9-7A (LO 9-7) Requirement 1 ($ in millions) Starwood Hyatt Total Liabilities ÷ Equity = Debt to Equity Ratio $5,724 $2,819 ÷ ÷ $3,137 $4,821 = = 1.82 0.58 Starwood Hotels and Resorts has a higher debt to equity ratio than Hyatt. The hotel industry represented by Starwood and Hyatt maintains a lower debt to equity ratio than the soft drink industry represented by Coca-Cola and Pepsi. Requirement 2 ($ in millions) Net Income Starwood $562 Hyatt $88 *($8,861 + $9,560) / 2 **($7,640 + $7,507) / 2 Average ÷ Total Assets ÷ ÷ = $9,210.5* = $7,573.5** = Return on Assets Ratio 6.1% 1.2% Average ($ in millions) Net Income Starwood $562 Hyatt $88 *($3,137 + $2,954) / 2 **($4,821 + $4,818) / 2 ÷ = Return on Equity Ratio = = 18.5% 1.8% Equity ÷ ÷ $3,045.5* $4,819.5** Starwood has better profitability ratios than Hyatt. However, Coca-Cola and Pepsi are both more profitable than Starwood . Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-43 Chapter 9 - Long-Term Liabilities Requirement 3 ($ in millions) Starwood Hyatt Net Income + Interest + Taxes ÷ Interest = Times Interest Earned Ratio $880 $166 ÷ ÷ $170 $70 = = 5.2 2.4 Starwood, with a times interest earned ratio of 5.2, is better able to meet interest payments as they become due than Hyatt with a ratio of only 2.4. The soft drink industry represented by Coca-Cola and Pepsi has a better times interest earned ratio than the Starwood and Hyatt hotel chains. © The McGraw-Hill Companies, Inc., 2014 9-44 Financial Accounting Chapter 9 - Long-Term Liabilities PROBLEMS: SET B Problem 9-1B (LO 9-3, 9-4) Requirement 1 Face amount. The issue price is $850,000. Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $850,000 $25,500 = $850,000 x 6% x ½ year 3% = 6% / 2 semi-annual periods 20 = 10 years x 2 periods each year Calculator Output Issue price PV (1) Date $850,000 (2) (3) Cash Paid Face Amount x 3% Stated Rate Interest Expense Carrying Value x 3% Market Rate 1/ 1 /15 6/30/15 12/31/15 Solutions Manual, Chapter 9 $ 25,500 25,500 $ 25,500 25,500 (4) Increase in Carrying Value (3) (2) $0 0 (5) Carrying Value Prior Carrying Value + (4) $ 850,000 850,000 850,000 © The McGraw-Hill Companies, Inc., 2014 9-45 Chapter 9 - Long-Term Liabilities Requirement 2 Discount. The issue price is $789,597. Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $850,000 $25,500 = $850,000 x 6% x ½ year 3.5% = 7% / 2 semi-annual periods 20 = 10 years x 2 periods each year Calculator Output Issue price (1) Date 1/ 1 /15 6/30/15 12/31/15 PV $789,597 (2) (3) Cash Paid Face Amount x 3% Stated Rate Interest Expense Carrying Value x 3.5% Market Rate $ 25,500 25,500 © The McGraw-Hill Companies, Inc., 2014 9-46 $ 27,636 27,711 (4) Increase in Carrying Value (3) (2) $ 2,136 2,211 (5) Carrying Value Prior Carrying Value + (4) $ 789,597 791,733 793,944 Financial Accounting Chapter 9 - Long-Term Liabilities Requirement 3 Premium. The issue price is $916,254. Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $850,000 $25,500 = $850,000 x 6% x ½ year 2.5% = 5% / 2 semi-annual periods 20 = 10 years x 2 periods each year Calculator Output Issue price PV (1) Date $916,254 (2) (3) Cash Paid Face Amount x 3% Stated Rate Interest Expense Carrying Value x 2.5% Market Rate 1/ 1 /15 6/30/15 12/31/15 Solutions Manual, Chapter 9 $ 25,500 25,500 $ 22,906 22,842 (4) Decrease in Carrying Value (2) (3) $ 2,594 2,658 (5) Carrying Value Prior Carrying Value (4) $ 916,254 913,660 911,002 © The McGraw-Hill Companies, Inc., 2014 9-47 Chapter 9 - Long-Term Liabilities Problem 9-2B (LO 9-4) Requirement 1 January 1, 2015 Cash Bonds Payable (Issue bonds at face amount) June 30, 2015 Interest Expense Cash ($3,000,000 x 9% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense Cash ($3,000,000 x 9% x ½) (Pay semiannual interest) Requirement 2 January 1, 2015 Cash Bonds Payable (Issue bonds at a discount) June 30, 2015 Interest Expense ($2,813,067 x 10% x ½) Bonds Payable (difference) Cash ($3,000,000 x 9% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense ([$2,813,067+$5,653] x10% x ½) Bonds Payable (difference) Cash ($3,000,000 x 9% x ½) (Pay semiannual interest) © The McGraw-Hill Companies, Inc., 2014 9-48 3,000,000 3,000,000 135,000 135,000 135,000 135,000 2,813,067 2,813,067 140,653 5,653 135,000 140,936 5,936 135,000 Financial Accounting Chapter 9 - Long-Term Liabilities Requirement 3 January 1, 2015 Cash Bonds Payable (Issue bonds at a premium) June 30, 2015 Interest Expense ($3,203,855 x 8% x ½) Bonds Payable (difference) Cash ($3,000,000 x 9% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense ([$3,203,855 $6,846] x 8% x ½) Bonds Payable (difference) Cash ($3,000,000 x 9% x ½) (Pay semiannual interest) 3,203,855 3,203,855 128,154 6,846 135,000 127,880 7,120 135,000 Problem 9-3B (LO 9-4) 1. Premium 2. $66,934,432 3. $60,000,000 4. 7% ($2,100,000 cash paid ÷ $60,000,000 face value) x 2 5. 6% ($2,008,033 interest expense ÷ $66,934,432 carrying value) x 2 6. $84,000,000 ($2,100,000 x 40 payments) Problem 9-4B (LO 9-4) Requirement 1 Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-49 Chapter 9 - Long-Term Liabilities (1) Date 1/ 1 /15 6/30/15 12/31/15 (2) (3) Cash Paid Face Amount x 3.5% Stated Rate Interest Expense Carrying Value x 3% Market Rate $ 35,000 35,000 $ 32,940 32,878 Requirement 2 January 1, 2015 Cash Bonds Payable (Issue bonds at a premium) Requirement 3 June 30, 2015 Interest Expense ($1,098,002 x 6% x ½) Bonds Payable (difference) Cash ($1,000,000 x 7% x ½) (Pay semiannual interest) December 31, 2015 Interest Expense ($1,095,942 x 6% x ½) Bonds Payable (difference) Cash ($1,000,000 x 7% x ½) (Pay semiannual interest) © The McGraw-Hill Companies, Inc., 2014 9-50 (4) Decrease in Carrying Value (2) (3) (5) Carrying Value Prior Carrying Value (4) $ 2,060 2,122 $ 1,098,002 1,095,942 1,093,820 1,098,002 1,098,002 32,940 2,060 35,000 32,878 2,122 35,000 Financial Accounting Chapter 9 - Long-Term Liabilities Problem 9-5B (LO 9-6) Requirement 1 January 1, 2015 Building Cash Notes Payable (Issue a mortgage note payable) Requirement 2 (1) (2) Date 1/1/15 1/31/15 2/28/15 610,000 110,000 500,000 (3) (4) (5) Cash Paid Interest Expense Decrease in Carrying Value Carrying Value Monthly Payment Carrying Value x 0.09 x 1/12 $5,071.33 5,071.33 $ 3,750.00 3,740.09 Requirement 3 January 31, 2015 Interest Expense ($500,000 x 9% x 1/12) Notes Payable (difference) Cash (monthly payment) (Pay monthly installment on note ) (2) (3) $ 1,321.33 1,331.24 Prior Carrying Value (4) $ 500,000.00 498,678.67 497,347.43 3,750.00 1,321.33 5,071.33 In the first monthly payment, $3,750.00 goes to interest expense and only $1,321.33 goes to reducing the carrying value of the loan. Requirement 4 Over the 15 year mortgage, $412,839 is interest expense and $500,000 goes to reducing the carrying value of the loan. Interest expense over the 15 year mortgage is calculated as the total payments of $912,839 minus the $500,000 carrying value of the loan. Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-51 Chapter 9 - Long-Term Liabilities Problem 9-6B (LO 9-6, 9-7) Requirement 1 Assets $201 million = Liabilities + $91 + $61 = $152 million Equity ? 49 million ($201 million - $152 million). Requirement 2 Total Liabilities $152 million ÷ ÷ Equity $49 million = = Debt to Equity Ratio 3.10 Requirement 3 An operating lease is like a rental. Over the lease term, the company making the lease payments records rent expense and the company receiving the rent payments records rent revenue. A capital lease is different. In a capital lease, the company making lease payments (called the lessee) essentially buys the asset and borrows the money through a lease to pay for the asset. The lease is recorded as an asset and a liability on ecords calculated as the present value of the lease payments. Requirement 4 Yes. The debt to equity ratio will not be affected under an operating lease. However, under a capital lease, assets and liabilities will both increase $26 million while stockholde the debt to equity ratio. © The McGraw-Hill Companies, Inc., 2014 9-52 Financial Accounting Chapter 9 - Long-Term Liabilities Requirement 5 The debt to equity ratio will not be in violation under an operating lease, but will be in violation under a capital lease. Therefore, Chunky Cheese Pizza has a strong incentive to structure the lease agreement as an operating lease. Operating lease: Total Liabilities $152 million ÷ ÷ Equity $49 million = = Debt to Equity Ratio 3.10 = = Debt to Equity Ratio 3.63 Capital lease: Total Liabilities $178 million Solutions Manual, Chapter 9 ÷ ÷ Equity $49 million © The McGraw-Hill Companies, Inc., 2014 9-53 Chapter 9 - Long-Term Liabilities Problem 9-7B (LO 9-7) Requirement 1 ($ in millions) Royal Caribbean Carnival Total Liabilities ÷ Equity = Debt to Equity Ratio $11,519 $14,302 ÷ ÷ $8,309 $19,098 = = 1.39 0.75 Royal Caribbean has a higher debt to equity ratio than Carnival. Royal Caribbean and Carnival have a lower debt to equity ratio in comparison to the soft drink industry represented by Coca-Cola and Pepsi. Requirement 2 ($ in millions) Net Income Royal Caribbean $18 Carnival $1,298 *($19,828 + $19,804) / 2 **($39,161 + $38,637) / 2 Average ÷ Total Assets = Return on Assets Ratio $19,816* $38,899** = = 0.1% 3.3% = Return on Equity Ratio ÷ ÷ Average Net Income ÷ Royal Caribbean $18 Carnival $1,298 *($8,309 + $8,408) / 2 **($23,929 + $23,832) / 2 ÷ ÷ ($ in millions) Equity $8,358.5* = $23,880.5** = 0.2% 5.4% Carnival has better profitability ratios than Royal Caribbean. However, Coca-Cola and Pepsi are both more profitable than Carnival. Requirement 3 © The McGraw-Hill Companies, Inc., 2014 9-54 Financial Accounting Chapter 9 - Long-Term Liabilities ($ in millions) Royal Caribbean Carnival Net Income + Interest + Taxes ÷ $374 $1,638 ÷ ÷ Interest = Times Interest Earned Ratio $356 $336 = = 1.1 4.9 Carnival, with a times interest earned ratio of 4.9, is better able to meet interest payments as they become due than Royal Caribbean with a ratio of only 1.1. The soft drink industry represented by Coca-Cola and Pepsi has a better times interest earned ratio than the Royal Caribbean and Carnival cruise lines. Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-55 Chapter 9 - Long-Term Liabilities ADDITIONAL PERSPECTIVES Continuing Problem: Great Adventures AP9-1 Requirement 1 (1) Date 1/ 1 /17 1/31/17 2/28/17 (2) (3) Cash Paid Monthly Payment Interest Expense Carrying Value x 6% x 1/12 $ 5,551 5,551 $ 2,500 2,485 Requirement 2 January 1, 2017 Cash Notes Payable (Issue a note payable) January 31, 2017 Interest Expense ($500,000 x 6% x 1/12) Notes Payable (difference) Cash (monthly payment) (Pay monthly installment on note ) February 28, 2017 Interest Expense ($496,949 x 6% x 1/12) Notes Payable (difference) Cash (monthly payment) (Pay monthly installment on note ) © The McGraw-Hill Companies, Inc., 2014 9-56 (4) Decrease in Carrying Value (2) (3) $ 3,051 3,066 (5) Carrying Value Prior Carrying Value (4) $ 500,000 496,949 493,883 500,000 500,000 2,500 3,051 5,551 2,485 3,066 5,551 Financial Accounting Chapter 9 - Long-Term Liabilities Financial Analysis: American Eagle AP9-2 Requirement 1 ($ in thousands) Total Liabilities ÷ Equity 2013 $534,866 ÷ $1,221,187 2012 $533,951 ÷ $1,416,851 The ratio weakened in the more recent year. = Debt to Equity Ratio = = 0.44 0.38 = Return on Equity = 17.6% Requirement 2 Average ($ in thousands) Net Income 2013 $232,108 *($1,416,851 + $1,221,187) / 2 ÷ Equity ÷ $1,319,019* Investors would obtain a higher return on equity if American Eagle borrowed more money since their return on equity (17.6%) exceeds their interest cost of borrowing (less than 10%). Requirement 3 The bankruptcy risk of American Eagle is very low. The company carries very little debt and has several large lines of credit that it could use to borrow in the future if necessary. Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-57 Chapter 9 - Long-Term Liabilities Financial Analysis: Buckle AP9-3 Requirement 1 ($ in thousands) Total Liabilities ÷ Equity 2013 $188,325 $289,649 ÷ 2012 $168,392 $363,147 ÷ The ratio weakened in the more recent year. = Debt to Equity Ratio = = 0.65 0.46 = Return on Equity = 50.3% Requirement 2 Average ($ in thousands) Net Income 2013 $164,305 *($363,147 + $289,649) / 2 ÷ Equity ÷ $326,398* Investors would obtain a higher return on equity if Buckle borrowed more money since their return on equity (50.3%) exceeds their interest cost of borrowing (less than 10%). Requirement 3 The bankruptcy risk of The Buckle is very low. The company carries no bank borrowings and has an unsecured line of credit of $25 million that it could use to borrow in the future if necessary. © The McGraw-Hill Companies, Inc., 2014 9-58 Financial Accounting Chapter 9 - Long-Term Liabilities Comparative Analysis: American Eagle vs. Buckle AP9-4 Requirement 1 ($ in thousands) Total Liabilities ÷ Equity = Debt to Equity Ratio American Eagle Buckle $534,866 $188,325 ÷ ÷ $1,221,187 $289,649 = = 0.44 0.65 American Eagle has a better (lower) debt to equity ratio. The ratios are both lower than those for Coca-Cola and Pepsi reported in the chapter. The soft-drink industry maintains a higher debt to equity ratio than the retail clothing industry. Requirement 2 ($ in thousands) Net Income American Eagle $232,108 Buckle $164,305 *($1,950,802 + $1,756,053) / 2 **($531,539 + $477,974) / 2 ÷ Average Total Assets = Return on Assets Ratio ÷ ÷ $1,853,428* $504,757** = = 12.5% 32.6% = Return on Equity Ratio = = 17.6% 50.3% Average ($ in thousands) Net Income American Eagle $232,108 Buckle $164,305 *($1,416,851 + $1,221,187) / 2 **($363,147 + $289,649) / 2 ÷ Equity ÷ ÷ $1,319,019* $326,398** Buckle has a better return on assets and return on equity ratio than American Eagle. Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-59 Chapter 9 - Long-Term Liabilities Ethics AP9-5 Requirement 1 Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $10,000,000 $250,000 = $10,000,000 x 5% x ½ year 4.5% = 9% / 2 semi-annual periods 14 = 7 years x 2 periods each year Calculator Output Issue price PV Requirement 2 December 31, 2015 Bonds Payable Gain Cash (Retire bonds before maturity) $7,955,435 10,000,000 2,044,565 7,955,435 Requirement 3 It is not ethical to deceive investors into thinking the $2 million gain is part of ongoing operating income. However, the repurchase of bonds itself is ethical assuming the company properly discloses the early retirement of 6% bonds and the reissue of 9% bonds. Requirement 4 In order to report the $2 million gain, the company will give up bonds with interest costing only $500,000 ($10 million times 5%) each year and reissue new bonds requiring interest payments of $900,000 ($10 million times 9%) each year. Not a good idea. © The McGraw-Hill Companies, Inc., 2014 9-60 Financial Accounting Chapter 9 - Long-Term Liabilities Internet Research AP9-6 This case provides an opportunity for students to learn more about credit ratings at business press. Answers to the assignment will vary depending on the news items chosen. Solutions Manual, Chapter 9 © The McGraw-Hill Companies, Inc., 2014 9-61 Chapter 9 - Long-Term Liabilities Written Communication AP9-7 Requirement 1 A company that borrows by issuing bonds is effectively by-passing the bank and borrowing directly from the investing public, usually at a lower interest rate than it would in a bank loan. However, issuing bonds entails significant bond issue costs for the underwriter, legal fees, and accounting costs. For smaller loans, the additional bond issuance costs exceed the savings from a lower interest rate, making it more economical to borrow from a bank. For loans of $20 million or more, the interest rate savings often exceed the additional bond issuance costs, making a bond issue more attractive. Requirement 2 One of the primary reasons for issuing bonds over issuing common stock relates to taxes. Interest expense incurred when borrowing money is tax deductible, while dividends paid to stockholders are not tax deductible. Therefore, debt can be a less costly form of financing. Requirement 3 The price of a bond is calculated as the present value of the principal (the face amount on the bond due at maturity) plus the present value of the periodic interest payments. The stated rate is used to calculate the periodic interest payment each period. The market rate is used to calculate the present value of the principal and periodic interest payments. © The McGraw-Hill Companies, Inc., 2014 9-62 Financial Accounting Chapter 9 - Long-Term Liabilities Earnings Management AP9-8 Requirement 1 Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $100,000,000 $3,000,000 = $100,000,000 x 6% x ½ year 2.5% = 5% / 2 semi-annual periods 30 = 15 years x 2 periods each year Calculator Output Issue price PV $110,465,146 Requirement 2 Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $100,000,000 $3,000,000 = $100,000,000 x 6% x ½ year 2.5% = 5% / 2 semi-annual periods 20 = 10 years x 2 periods each year Calculator Output Issue price Solutions Manual, Chapter 9 PV $107,794,581 © The McGraw-Hill Companies, Inc., 2014 9-63 Chapter 9 - Long-Term Liabilities Requirement 3 Calculator Input Bond Characteristics 1. Face amount 2. Interest payment 3. Market interest rate 4. Periods to maturity Key FV PMT I N Amount $100,000,000 $3,000,000 = $100,000,000 x 6% x ½ year 4.5% = 9% / 2 semi-annual periods 20 = 10 years x 2 periods each year Calculator Output Issue price PV $80,488,095 Requirement 4 December 31, 2017 Bonds Payable 107,794,581 Gain 27,306,486 Cash 80,488,095 (Retire bonds before maturity) The transaction increases net income by the amount of the gain, $27,306,486. Requirement 5 David Plesko’s plan is ethical as long as he properly discloses the early retirement of 6% bonds and the reissue of 9% bonds. However, investors would probably disagree with David Plesko’s plan. In order to report the $27 million gain on repurchase, the company will give up bonds costing only $6 million ($100 million times 6%) in interest each year and reissue new bonds requiring the payment of $9 million ($100 million times 9%) in interest each year. © The McGraw-Hill Companies, Inc., 2014 9-64 Financial Accounting