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241
PROBLEMS
P8–1
1. Plan 1 Plan 2 Plan 3
Earnings before interest and income tax ...... $1,000,000 $1,000,000 $1,000,000
Deduct interest on bonds ............................... 0 0 (200,000)
Income before income tax .............................. $1,000,000 $1,000,000 $ 800,000
2. Plan 1 Plan 2 Plan 3
Earnings before interest and income tax ...... $ 300,000 $300,000 $300,000
Deduct interest on bonds ............................... 0 0 (200,000)
Income before income tax .............................. $ 300,000 $300,000 $100,000
3. The principal advantage of Plan 1 is it involves only the issuance of common
stock, which does not require a periodic interest payment or return of
principal, and a payment of preferred dividends is not required. However, it
provides the lowest EPS when earnings before interest and income tax is
$1,000,000.
242
P8–1, Concluded
Plan 2 provides an EPS of $0.16 when earnings before interest and income
tax is $300,000, which is lower than Plan 1, but higher than Plan 3. Plan 2 pro-
vides an EPS of $1.00, which is higher than Plan 1 when earnings before
243
P8–2
1. $3,375 ($45,000 × 7.5%)
2.
Balance Sheet
Assets = Liabilities + Stockholders’ Equit
y
Cash
Employee FICA Bond Group
=
Income Tax
Pa
y
able +
Tax
Pa
y
able +
Deduction
Pa
y
able +
Ins.
Pa
y
able +
Retained
Earnin
g
s
244
P8–2, Concluded
3. (a) $3,375 ($45,000 × 7.5%)
(b) $1,890 ($45,000 × 4.2%)
(c) $360 ($45,000 × 0.8%)
4.
Balance Sheet
Assets = Liabilities + Stockholders’ Equit
y
FICA Tax SUTA FUTA Retained
245
P8–3
1.
Balance Sheet
Assets = Liabilities + Stockholders’ Equit
y
Cash = Bonds Pa
y
able
Jul
y
1. 25,000,000 25,000,000
Statement of Cash Flows Income Statement
Jul
y
1. Financin
g
25,000,000 No effect 0
2.
Balance Sheet
Assets = Liabilities + Stockholders’ Equit
y
Retained
3.
Balance Sheet
Assets = Liabilities + Stockholders’ Equit
y
Cash = Bonds Pa
y
able
June 30.
(
25,000,000
)
(
25,000,000
)
Statement of Cash Flows Income Statement
June 30. Financin
g
(
25,000,000
)
No effect 0
4. The bonds would have sold at a premium since the market rate of interest
would have been less than the coupon rate of interest. Thus, investors would
246
P8–4
Balance Sheet
Assets = Liabilities + Stockholders’ Equit
y
Mortgage
Balance Sheet
Assets = Liabilities + Stockholders’ Equit
y
Preferred Paid-In Capital in Excess
Cash = Stock + of Pa
r
—Preferred Stock
Mar. 13. 2,600,0001 2,400,0002 200,0003
Statement of Cash Flows Income Statement
Mar. 13 Financing 2,600,000 No effect 0
1$2,600,000 = 20,000 shares × $130
Balance Sheet
Assets = Liabilities + Stockholders’ Equity
Common Paid-In Capital in Excess
P8–5
1.
Total Preferred Dividends Common Dividends
Year Dividends Total Per Share Total Per Share
Year 1 .................... $ 28,000 $28,000 $ 0.70 $ 0 $ 0
Year 2 .................... 44,000 44,000 1.10 0 0
$ 6.90 $ 2.40
2. Average annual dividend for preferred: $1.15 per share ($6.90 ÷ 6)
Average annual dividend for common: $0.40 per share ($2.40 ÷ 6)
3. a. 2.0% ($1.15 ÷ $57.50)
248
METRIC-BASED ANALYSIS
MBA 8–1
Solvency Metric Profitability Metric
Net Assets Earnings per Share
MBA 8–2
Solvency Metric Profitability Metric
Net Assets Earnings per Share
1. Paying payroll ................................ $(45,000) Decrease
MBA 8–3
Solvency Metric Profitability Metric
Net Assets Earnings per Share
1. Issuing bonds payable .................. No Effect No Effect
2. Paying interest ............................... $(1,000,000) Decrease
3. Paying face value at maturity ....... No Effect No Effect
MBA 8–4
Solvency Metric Profitability Metric
Net Assets Earnings per Share
MBA 8–5
Solvency Metric Profitability Metric
Net Assets Earnings per Share
1. Purchasing treasury stock ............ $(990,000) Increase
249
MBA 8–6
Solvency Metric Profitability Metric
Net Assets Earnings per Share
MBA 8–7
Solvency Metric Profitability Metric
Net Assets Earnings per Share
6-for-1 stock split ................................... No Effect Decrease
MBA 8–8
1. Year 2 Year 1
Debt ratio:
($43,075 ÷ $44,529) ....................................... 96.7%
($38,633 ÷ $42,966) ....................................... 89.9%
2. Ratio of stockholders’ equity to total assets:
(100.0 – 96.7%) or ($1,454 ÷ $44,529) .......... 3.3%
(100.0 – 89.9%) or ($4,333 ÷ $42,966) .......... 10.1%
7. The price-earnings ratio has increased from 20.1 in Year 1 to 25.7 in Year 2.
This increase in the price-earnings ratio implies the market has changed its
250
MBA 8–9
1. 83.4% ($29,418 ÷ $35,291)
2. 16.6% (100.0% – 83.4%) or ($5,873 ÷ $35,291)
3. Lowe’s operations are financed primarily with debt. The debt ratio and ratio of
stockholders’ equity to total assets indicate that total liabilities exceed total
stockholders’ equity.
4. 24.6 ($100.53 ÷ $4.09)
MBA 8–10
1. Year 2 Year 1
Debt ratio:
($44,793 ÷ $197,295) ..................................... 22.7%
($28,461 ÷ $167,497) ..................................... 17.0%
2. Ratio of stockholders’ equity to total assets:
(100.0% – 22.7%) or ($152,502 ÷ $197,295) . 77.3%
(100.0% – 17.0%) or ($139,036 ÷ $167,497) . 83.0%
251
MBA 8–10, Concluded
5. Total liabilities have increased as a percent of total assets in Year 2; thus,
creditors would feel less safe. However, the large amount of equity
financing implies that creditors have little to worry about.
6. 58.1 ($1,046.40 ÷ $18.00)
MBA 8–11
Debt Ratio Price-Earnings Ratio
More than 50% (Yes, No) Above 10 (Yes, No)
Alcoa Yes Yes
Amazon.com Yes Yes
Boeing Yes Yes
Note to Instructors: The objective of this problem is to get students to think about
these companies and what they would expect for each company’s ratio of liabili-
ties to total assets. We would expect that most established and well-known com-
panies would have ratios of liabilities to total assets that exceed 50%. Doing so
enables companies to take advantage of financial leverage to increase returns to
252
Case 8–1
1. The so-called “underground economy” hides transactions from IRS scrutiny
by conducting business with cash (not check or credit card, which leaves an
audit trail). The intent in many such transactions is to evade payroll taxes
2. Jas should respond that he would rather receive a payroll check as a normal
employee does. Receiving cash as an employee, rather than a payroll check,
subverts the U.S. tax system. That is, such cash payments do not include
Case 8–2
This activity does not require the student to research the contingency notes for
the Altria Group. The contingency disclosure is extensive and complicated.
Rather, the student should identify Altria Group’s main business and, from this
information, determine the likely cause of the contingency disclosures
1. Altria Group is a holding company for a number of businesses including Philip
Morris. Thus, Altria’s primary business is in the manufacture and distribution
of tobacco products.
253
Case 8–3
1. This case involves a transaction in which a security has been issued that has
characteristics of stock and debt. The primary argument for classifying the
issuance of the common stock as debt is that the investors have a legal right
to an amount equal to the purchase price of the security. This is similar to a
note payable or a bond payable. It could be argued that the additional $50
payment could be equivalent to an interest payment, whose payment has
been deferred until a later date.
2. In practice, the $25 million stock issuance would probably be classified as
common stock. However, full disclosure should be made of the 2% of sales
and $50 per share payment obligation in the notes to the financial statements.
In addition, as Sahara Unlimited Inc. generates sales, a current liability should
254
Case 8–4
The primary advantage of issuing preferred stock rather than bonds is the
preferred stock does not obligate Living Smart to pay dividends, yet interest on
bonds must be paid. That is, the issuance of bonds will require annual interest
Case 8–5
1. Plan 1 Plan 2
Shares of common stock .............................................. 400,000 500,000
Earnings before bond interest and income tax ........... $1,200,000 $1,200,000
Deduct interest on bonds .............................................. (480,000) (280,000)
Income before income tax ............................................. $ 720,000 $ 920,000
2. a. Factors to be considered in addition to earnings per share:
A definite legal obligation exists to pay interest on bonds, but there is
no definite commitment to pay dividends on common stock. Therefore,
if net income should drop substantially, bonds would be less desirable
than common stock.
