Chapter 7
Financing Activities
7-21
c. (1) For both Coca-Cola and Eli Lilly, the options have a 10-year life.
(2) The vesting periods are less than the options life. This allows the option
(3) The weighted-average expected life of the options is 6.0 years for Coca-
Cola and 7.2 years for Eli Lilly. Although grantees can hold the options up
d. GAAP does not require a specific option-pricing model. However, any model
must incorporate a variety of factors, including the exercise price of the option,
7.22 Interpreting Stock Option Disclosures.
a. Firms structure stock option plans so that a period of time elapses between the
b. The fair value of the options granted increased between Year 2 and Year 3 in
part because the market price of the firm’s common stock increased between
Chapter 7
Financing Activities
7-22
c. Year 2: 29.146 × ($31.86 – $9.45) = $653.16 million
d. Many firms have concluded that the forgone cash flows from selling shares of
e. The firm would report compensation expense of $424.55 million for Year 2
f. (1) This method ignores the economic cost to the firm and the benefit to
(2) This method attempts to measure the value of options at the time of the
(3) This method recognizes the ultimate, realized benefit to employees and the
7-23
7.23 Hedging Interest Rate Risk
SOLUTION TO PART A
The following schedule summarizes the financial statement effects. Explanations follow.
Fair Value Hedge: Interest Rate Swap to Convert Fixed-Rate Debt to Variable-Rate
Debt
Assets = Liabilities + Shareholders’ Equity
CC AOCI RE
Interest Expense 20,000
Cash 20,000
Loss on Revaluation of Notes Payable 14,143
Notes Payable 14,143
Swap Contract +5,000
Revaluation of note:
Gain on Revaluation
Chapter 7
Financing Activities
7-24
Swap Contract 18,864
December 31, 2019
Interest expense on note:
Interest expense on swap contract
liability:
Swap Contract +465 Interest Expense (465)
Cash payment to counterparty:
Interest Expense 24,535
January 1, 2017
January 31, 2017
• FD makes the required interest payment of $20,000 (0.04 × $500,000) on the note
Note Payable on the income statement in the same amount.
Chapter 7
Financing Activities
7-25
• The decline in the interest rate to 3% means that FD will save $5,000 each year in
interest payments. The present value of a $5,000 annuity for three remaining peri-
December 31, 2018
• FD records interest expense on the note payable using the effective interest meth-
od. The effective interest rate for 2018 is 3%, and the book value of the note paya-
by the amount of interest each year. Interest expense (net) as a result of the two
entries is $15,000 ($15,424 interest expense – $424 interest revenue), which is the
variable rate for 2018 of 3% times the $500,000 face value of the note.
• FD receives $5,000 under the swap contract with its counterparty because the
interest rate decreased from 4% to 3% [$500,000 × (0.04 – 0.03)], which also re-
contract from a $9,567 asset to a $9,297 liability results in a $18,864 loss on
revaluation of swap contract reflected in the income statement. The gain on
revaluation of the note exactly offsets the loss on revaluation of the swap contract,
so the swap contract hedges the change in interest rates.
Chapter 7
Financing Activities
7-26
December 31, 2019
Chapter 7
Financing Activities
7-27
SOLUTION TO PART B
The following schedule summarizes the financial statement effects. Explanations follow.
Cash Flow Hedge: Interest Rate Swap to Convert Variable-Rate Debt to
Fixed-Rate Debt
Assets = Liabilities + Shareholders’ Equity
CC AOCI RE
Interest Expense 20,000
Cash 20,000
Loss on Revaluation of Swap Contract (OCI) 14,143
Swap Contract 14,143
December 31, 2018
Reclassification of a portion of
other comprehensive income:
OCI—Swap
Contract +5,000 Interest Expense (5,000)
Revaluation of swap contract:
OCI—Swap
Interest Expense 5,000
OCI—Swap Contract 5,000
Swap Contract 18,864
Chapter 7
Financing Activities
7-28
December 31, 2019
Interest expense on note:
OCI—Swap
Contract (5,000) Interest Expense +5,000
Interest Expense 25,000
Cash 25,000
January 1, 2017
December 31, 2017
The fair value of the note in this case, unlike Scenario 1, will not change as interest rates
December 31, 2018
• FD pays the (now) $15,000 interest on the variable-rate note and recognizes
Chapter 7
Financing Activities
7-29
• FD pays the counterparty the $5,000 [$500,000 × (0.04 – 0.03)] required by the
reduced to a debit balance (that is, a net subtraction from shareholders’ equity) of
$9,567. Interest expense on the income statement is $20,000 ($15,000 + $5,000).
• Restating the interest rate on December 31, 2018, for the year 2019 to 5%
changes the value of the swap contract from a liability to an asset. The present
comprehensive income for 2018 is $23,440 ($5,000 + $18,864 – $424), which in-
creases accumulated other comprehensive income from its $14,143 debit balance
at the end of 2017 to a $9,297 credit balance at the end of 2018. This credit bal-
ance equals the balance in the swap contract asset account.
December 31, 2019
• FD pays the (now) 5% interest on the loan and recognizes interest expense. FD
In summary, note that interest expense is $20,000 each year, the fixed rate of 4% that FD
Chapter 7
Financing Activities
7-30
Integrative Case 7.1: Walmart
a. Suggested solution; other solutions using different assumptions are possible.
Fiscal Year Lease Payment Present Value Factor at 5% Present Value
Interest rate computed by dividing interest expense for the fiscal year ending January 31,
2016, by the average of the January 31, 2016, and January 31, 2015, interest-bearing
debt:
b. Adjust the numerator and denominator of the ratio by the present value of the
Chapter 7
Financing Activities
7-31
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Long-term debt + Long-term capital leases = $38,214 + $5,816 = $44,030 million
Shareholders’ equity = $83,611 million
Unadjusted long-term debt to long-term capital ratio = $44,030/($44,030 + $83,611)
= 34.5%
Adjusted long-term debt to long-term capital ratio = ($44,030 + $13,473.9)/
Case 7.2: Oracle Corporation: Share-Based Compensation Effects/Statement of
Shareholders’ Equity
a. Long-term debt to shareholders’ equity ratio (all amounts from Exhibit 6.20):
Chapter 7
Financing Activities
7-32
(Chapters 12–14 discuss the valuation effects of changes in leverage. Although
ROE is levered upward, increased financial risk increases both the cost of equi-
ty and debt financing.)
b. The decrease in retained earnings occurred because Oracle (a) paid more to
reacquire the shares compared to the shares’ original issue price and (b) retired
claims were lodged: the original contributed capital accounts, common stock and
retained earnings.
c. Common stock awarded under stock award plans: Cash inflow represents exer-
Common stock awarded under stock purchase plans: Cash inflow represents
Assumption of stock awards in conjunction with acquisitions: Presumably, Ora-
Stock-based compensation: Not a cash flow, although it reduces net income;
Chapter 7
Financing Activities
7-33
d. All increases in net assets from transactions with nonowners increase sharehold-
e. Opponents of the other comprehensive income approach dislike the exclusion of
gains and losses from net income. Doing so, they argue, hurts the ability of net
f. Oracle will not report a loss from allowing its employees to purchase shares at
95% of market value. Plans in which broad employee participation is allowed, the
Chapter 7
Financing Activities
7-34
Case 7.3: Long-Term Solvency Risk: Southwest and Lufthansa Airlines
a. Summary Discussion
LTD to OCF to Interest
Liabilities Shareholders’ Total Coverage
to Assets Equity Liabilities (Cash Basis)
As Reported:
Lufthansa: 2007 69.1% 44.9% 18.6% 17.2 times
Adjusted for Operating
SWA’s long-term solvency risk increased between 2007 and 2008. The ratio of
total liabilities to assets increased from 58.5% to 65.4%. LTD relative to share-
ratio. Lufthansa’s CFO to total liabilities ratio also is below 20%.
Chapter 7
7-35
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Capitalization of the operating leases caused both firms’ risk ratios to deterio-
rate. Most notably, the LTD to shareholders’ equity ratios increased substantial-
ly in both years for each firm.
Supporting computations for the ratios appear next.
LTD to OCF to Interest
Liabilities Shareholders’ Total Coverage
to Assets Equity Liabilities (Cash Basis)
As Reported:
SWA: 2008 $–1,521/
SWA: 2007 $2,845/
Lufthansa: 2008 2,473/
Lufthansa: 2007 2,862/
Adjusted for
Operating Leases:
= 69.0% = 97.3% = –9.7% = –4.7 times
SWA: 2007 ($16,772 – ($2,845 +
Chapter 7
Financing Activities
7-36
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Lufthansa: 2008 (6,898 + (2,473 +
(amounts in euros) 8,591 + (3,161 + 331.466)/
2,439.66)/ 2,439.66 – (6,898 + (2,473 + 331.466 +
(22,408 + 460.22)/ 8,591 + 172 + 168.34 + 123)/
2,439.66) 6,919 2,439.66) (172 + 168.34)
= 72.2% = 74.3% = 15.6% = 9.6 times
Lufthansa: 2007 (7,149 + (2,862 +
Supporting Computations for SWA:
Estimate of SWA’s Interest Rate:
Southwest Operating Lease Capitalization: 2008
Operating
Lease Present Value Present
Year Commitments Factor at 4.5% Value
*Present value of an annuity of $145.6 million for five periods at 4.5%; then
Chapter 7
Financing Activities
7-37
Southwest Operating Lease Capitalization: 2007
Operating
Lease Present Value Present
Year Commitments Factor at 4.5% Value
*Present value of an annuity of $175.2 million for five periods at 4.5%; then
Restatement of Operating Cash Flow (2008):
These cash flow effects are rough estimates, particularly interest expense because
it is based on the ending balance of the liability. An alternative (and more correct)
pense was used.
2007:
Rent expense in 2007 (per Note 8) which would be added back to
Chapter 7
Financing Activities
7-38
Supporting Computations for Lufthansa:
Estimate of Lufthansa’s Interest Rate:
Lufthansa Operating Lease Capitalization: 2008
Operating
Lease Present Value Present
Year Commitments Factor at 6.9% Value
After 2013 per annum 271 * 798.08
Total 2,439.66
Lufthansa Operating Lease Capitalization: 2007
Operating
Lease Present Value Present
Year Commitments Factor at 6.9% Value
*Assuming same average lease term as SWA (10 years). Present value of an
Chapter 7
Financing Activities
7-39
Restatement of Operating Cash Flow (2008):
Rent expense in 2008 (not disclosed; assumed to be approximately
2007:
b. For two reasons, firms reporting under IFRS are more likely to report higher
value calculations to yield lower amounts of reported restructured debt.
Chapter 7
Financing Activities
7-40
This page is intentionally left blank