CHAPTER 9

Financing Activities
THINKING BEYOND THE QUESTION What are the fundamental accounting issues associated with financing activities? Debt increases a companys financial risk. The debt and interest on the debt have to be paid by the borrower. If a company fails to make these payments when they are due, the company can be forced to seek protection in bankruptcy and may be forced to liquidate its assets to repay the amounts owed. However, the use of debt can also increase return to a companys stockholders. If a company can borrow at 8%, for example, and earn 12% on the additional operations financed by its borrowing, it is earning an extra 4% for its stockholders. Managers analyze the trade-off between risk and return. That trade-off depends on many factors, including the volatility of a companys earnings and cash flows and managements expectations about future earnings and growth potential. A company with volatile earnings and cash flows runs a higher risk of being unable to meet debt payments. A company with good growth opportunities can use debt to help finance that growth. QUESTIONS Q9-1 Liabilities are sometimes liquidated with resources other than cash, but it is cash that is most often used. Therefore, separation of liabilities into short-term and long-term categories distinguishes immediate needs for cash from those that are not so immediate. Once the more immediate needs for cash are identified, the reader of the balance sheet can assess the adequacy of short-term resources available to meet those cash needs. Failure to separate short-term liabilities from long-term liabilities would make such an assessment difficult. Q9-2 Debentures are unsecured bonds. This means there is no specific collateral backing for the bonds. Specific assets are not pledged as security. Instead, bondholders rely on the general credit worthiness of the company to back up the bonds. Serial bonds come due, a portion at a time, over a period of years. This is in contrast to bond issues in which all bonds come due for repayment at the same date. Callable bonds are bonds that a company can reacquire prior to their maturity date, after they have been outstanding for a specified period of time.

233

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Q9-3 The stated rate (nominal rate) is the interest rate that is printed on the face of the bond. When multiplied by the face value of the bond, it determines the amount of interest that will be paid to bondholders each period. The effective rate is the actual rate of return that is earned by a bondholder during the period. The stated rate and the effective rate are identical when the bond is acquired at face value. The stated rate differs from the effective rate whenever the bond is acquired at a price different from the face value. Q9-4 A capital lease is simply a means of financing the acquisition of assets. For example, a capital lease has the same economic effects as if a company borrowed money from a bank and then used that money to purchase a resource outright from a seller. First, in both a purchase and a capital lease, the buyer receives exclusive right to use the resource for most (or all) of its useful life. Second, in both a purchase and capital lease, the buyer must make payments to acquire the resource. Third, in both a purchase and capital lease, the buyer incurs interest expense to finance the asset. Under a capital lease the buyer makes payments to the lessor rather than making payments to a bank. Under a capital lease, a lessor provides one-stop service. It provides both a selling function and a financing function at the same time. Overall, however, the economic effects are the same as if the resource had been purchased from one party and financed by another. Q9-5 A contingency is an existing condition that may result in an economic effect if a future event occurs. A liability, on the other hand, is an existing obligation that has arisen because of an event that has already occurred. Under certain circumstances, contingencies must be reported as liabilities. This is required when it is probable that the contingency will result in a loss and that the amount of the loss can be reasonably estimated. Q9-6 A contingency arises from a possibility that some future event might take place. Whether the future event will occur or not is uncertain. A commitment, on the other hand, is a promise that some future event will take place. Commitments usually arise through agreement to buy or sell something in the future. Leases are a good example of commitments. Q9-7 I do not agree. Contributed capital includes only those items of stockholders equity that resulted from a direct contribution by the owners to the company. This would include common stock, paid-in capital in excess of par, and preferred stock. It does not include retained earnings. Retained earnings represents capital that has been earned by the company. It does not represent capital that was contributed. Therefore, it should not be included in a list of items comprising contributed capital.

Financing Activities

235

Q9-8 Yes, I agree. Most, but not all, current liabilities arise from operating activities. Examples of current liabilities commonly found on balance sheets include (1) accounts payable, (2) income taxes payable, (3) wages payable, and (4) current portion of long-term debt. There are others. (1) Accounts payable generally arise from purchasing inventory on credit. This is an operating activity because it deals with providing goods and services to customers. (2) Income taxes payable arise from providing goods and services to customers profitably. Therefore, income taxes payable arise from operating activities. (3) Wages payable arise when labor services are consumed but not yet paid for. Labor services are generally consumed in the process of providing goods or services to customers. Therefore, wages payable arise from operating activities. (4) The current portion of long-term debt arises when a long-term liability is due to be repaid within one year. The incurrence of long-term debt is a financing activity. Therefore, the current portion of long-term debt is the result of a financing activity. Q9-9 Beach Club Inc. should increase its cash account by $200,000, increase its common stock account by $50,000, and increase its Paid-In Capital in Excess of Par Value by $150,000. Q9-10 Most companies report the detailed changes in stockholders equity accounts in a financial statement titled Statement of Stockholders Equity (sometimes it is called the Statement of Changes in Stockholders Equity). As an alternative, many firms report these changes via a note to the financial statements. Under either approach, the information presented is the same. Q9-11 The difference is that the purchase and sale of widgets involves an external partya customer. Revenues are generated from selling goods and services to customers, and expenses are incurred during the same process. Similarly, gains are generated (or losses incurred) from dealings with parties external to the organization. Stockholders are not external parties, they are the owners. GAAP do not permit the owners of a company to generate profits or incur losses from selling shares of the companys own stock. Q9-12 The three terms concern the distribution of dividends. The date of declaration is the date that the board of directors announce that a dividend will be paid. The date of record establishes who will receive the dividend. Whoever owns the stock on that date will receive the dividend. The date of payment is the date on which checks are sent to the holders of record. Examples will vary but might include: On March 13, the Board of Directors of Big Corporation voted to pay a dividend of $0.13 per share to holders of record on April 15, payable on April 30. The date of

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declaration is March 13, the date of record is April 15, and the date of payment is April 30. Q9-13 Instead of voting rights, the preferred stockholders generally have a dividend preference and a liquidation preference over common stockholders. That is, if dividends are to be paid in any given period, the preferred dividends for that period must be paid in full before any dividends are paid to common stockholders. A liquidation preference means that in case a company is liquidated, the preferred stockholders stand in line before the common shareholders in receiving their investment. In these two ways, then, an investment in preferred stock is less risky than an investment in common stock. Q9-14 The dividend preference only protects preferred shareholders during the current period. If preferred stock is not cumulative, a choice by the Board of Directors to bypass dividends in a given year means the preferred dividend is probably lost and gone forever. A double-size dividend can be paid to common stockholders during the next year while only paying the annual dividend to preferred. The omitted preferred dividend does not need to be made up. The cumulative feature means that if a preferred dividend is skipped for a period, it must be made up in full before common dividends can ever be paid again. Q9-15 This is the risk-return trade-off at work. Investors are rewarded for taking on risk. The more risk an investor is willing to accept, the greater are the potential rewards. If an investor desires to limit risk, the investor automatically limits the rewards that can be earned. In this case, preferred stock is more risky than an investment in bonds. Bond interest is a required payment that must be made before dividends can be distributed. Also, preferred stock is more risky than bonds because in a liquidation, bondholders get paid before preferred shareholders. Compared to common stock, however, preferred stock is less risky. Therefore, the expected return on preferred stock is less than on common stock. Q9-16 Contributed capital is the term that describes direct stockholder investments in a corporation. When an investor purchases stock from a corporation, the funds collected by the corporation are called contributed capital. Common stock is that category of stock that controls the corporation through its voting privilege. Each share of common stock has one vote. Common stock receives a dividend that varies according to profits earned and decisions of the board of directors. Capital stock is an alternative term for common stock.

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237

Preferred stock is another class of stock that may be issued in addition to common stock. It has a higher claim on dividends and assets than common stock, which makes it a less risky class of stock for investors to own. The dividend on preferred stock is a fixed, stated amount. Preferred stock generally does not have voting rights. Treasury stock is the term used to describe shares of a corporation that once were in the hands of stockholders but have been reacquired by the issuing company. Treasury stock does not receive dividends nor does it have voting rights.

EXERCISES E9-1 Definitions of all terms are listed in the glossary. E9-2 a. PV of bonds = PV of annuity + PV of single amount PV of bonds = $80,000 3.88965 (5 periods, 9%) + $1,000,000 0.64993 (5 periods, 9%) PV of bonds = $311,172 + $649,930 Issue price = $961,102 PV of bonds = PV of annuity + PV of single amount PV of bonds = $80,000 4.32948 (5 periods, 5%) + $1,000,000 0.78353 (5 periods, 5%) PV of bonds = $346,358 + $783,530 Issue price = $1,129,888 At 8%, the bonds would sell at part or maturity value = $1,000,000 The bonds sold at a discount. Buyers paid less than the face value of the bonds so they could earn a higher return on the bonds than the stated rate. Therefore, interest expense recognized by the issuer would be greater than interest paid on the bonds each year. The bonds sold at a premium. Buyers paid more than the face value of the bonds and earned a lower return on the bonds than the stated rate. Therefore, interest expense recognized by the issuer would be less than interest paid on the bonds each year. The bonds sold at face value, and buyers earned the stated rate. Therefore, interest expense recognized by the issuer would be equal to interest paid on the bonds each year.

b.

c. E9-3 a.

b.

c.

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Chapter 9

E9-4

a.

$746,320

Interest expense would be the effective rate times the present value of the bonds at the beginning of the 2008 fiscal year: 0.08 $9,329,000 = $746,320.

b.

$9,375,320 The net liability is the present value of the bonds on September 30, 2008. It can be computed by adjusting the beginning-of-year present value by the amortization for the year. The amount of discount amortized in 2008 would be the interest expense minus the amount of interest paid: $746,320 $700,000 = $46,320. The net liability (bonds payable) reported on the balance sheet would be $9,329,000 + $46,320 = $9,375,320. $7,671,000 The total expense for the bonds over 10 years would be the interest paid for the period, which is $7,000,000 ($700,000 10 years) plus the original discount that is amortized over the 10 years, which is $671,000 ($10,000,000 $9,329,000). Thus, the total expense would be $7,000,000 + $671,000 = $7,671,000. Income statement: The income statement would report a gain on extinguishment of debt of $11,400 ($186,400 $175,000). This would raise net income by the same amount (ignoring taxes). Balance sheet: The balance sheet would report $175,000 less cash and $186,400 less long-term liabilities. Retained earnings would be $11,400 higher because of the gain on sale reported on the income statement. Statement of cash flows: The financing activities section of the statement of cash flows would report a cash outflow of $175,000 from buying back debt. If the indirect approach is used to report operating activities, the net income number would be $11,400 higher (ignoring taxes).

c.

E9-5

a.

b.

c.

E9-6
Account a. b. Cash Bonds Payable Interest Expense Cash Bonds Payable Bonds Payable Cash Debit 360,728 360,728 28,858 28,000 858 400,000 400,000 400,000 28,000 +858 400,000 Credit A +360,728 +360,728 28,858 = L+ OE CC + RE

c.

Financing Activities

239

E9-7 a.

$629,503 Proof: PV of bonds = PV of annuity (interest) + PV of maturity value PV = $42,000 4.91732 (Table 4, 6 periods, 6%) $206,527 + $600,000 0.70496 (Table 3, 6 periods, 6%) 422,976 $629,503

b. A B C D E Amortizatio n of Principal (Column C Column D) (4,230) (4,484) (4,753) (5,038) (5,340) (5,661) (29,506) F Value at End of Year (Column B + Column E) 625,273 620,789 616,036 610,998 605,658 600,000*

Interest PV at Incurred Beginning (Column B Year of Year Interest Rate) 1 629,503 37,770 2 625,273 37,516 3 620,789 37,247 4 616,036 36,962 5 610,998 36,660 6 605,658 36,339 Totals 222,494 *Ignore the $3 rounding error. c.
Account Jan. 1, 2007 Cash Bonds Payable Dec. 31, 2007 Interest Expense Bonds Payable Cash Dec. 31, 2012 Interest Expense Bonds Payable Cash Dec. 31, 2012 Bonds Payable Cash Debit 629,503

Amount Paid 42,000 42,000 42,000 42,000 42,000 42,000 252,000

Credit 629,503

A +629,503

L+ +629,503

OE CC + RE

37,770 4,230 42,000 36,339 5,661 42,000 600,000 600,000 600,000 42,000 42,000

37,770 4,230 36,339 5,661 600,000

E9-8

a.

$4,795,010 Present value of bonds = PV of annuity (interest) + PV of maturity value PV = $300,000 4.10020 (Table 4, 5 periods, 7%) + $5,000,000 0.71299 (Table 3, 5 periods, 7%) PV = $1,230,060 + $3,564,950 = $4,795,010

The bonds sold for an amount less than the face amount; i.e., at a discount. This occurred because the bonds will pay interest at a lesser rate than the market rate.

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(continued) b. $5,216,494 Present value of bonds = PV of annuity (interest) + PV of maturity value PV = $300,000 4.32948 (Table 4, 5 periods, 5%) + $5,000,000 0.78353 (Table 3, 5 periods, 5%) PV = $1,298,844 + $3,917,650 = $5,216,494

The bonds sold for an amount greater than the face amount; i.e., at a premium. This occurred because the bonds will pay interest at a greater rate than the market rate. c. $1,704,990 For the bonds in part (a), those sold at a discount, the interest expense over the five-year period would be the total interest paid plus the amount of the discount amortized. Interest expense = ($300,000 per year 5 years) + ($5,000,000 $4,795,010) Interest expense = $1,500,000 + $204,990 = $1,704,990 $1,283,506 For the bonds in part (b), those sold at a premium, the interest expense over the five-year period would be the total interest paid less the amount of the premium amortized. Interest expense = ($300,000 per year 5 years) + ($5,216,494 $5,000,000) Interest expense = $1,500,000 $216,494 = $1,283,506 The interest expense for the bonds sold at a discount would be greater than the amount of interest paid; the expense for the bonds sold at a premium would be less than the amount of interest paid. E9-9 This exercise requires students to determine the present value of lease payments and to separate the first lease payment into its interest component and its reduction of liability component. Entries are required (a) at the beginning of the lease and (b) at the date of the first lease payment.
Account a. Debit Credit 20,226 A +20,226* +20,226 = L+ OE CC + RE

Diagnostic Equipment 20,226* Capital Lease Obligation

*Present value of lease payments $5,200 3.88965 = $20,226 b. Interest Expense Capital Lease Obligation Cash 1,820* 3,380 5,200 5,200 1,820* 3,380

Financing Activities *Interest expense $20,226 9% = $1,820

241

E9-10 a. b. c.

d. e. f. E9-11

Liability; Notes Payable; current Liability; Capital Lease; long-term No liability (because there is not yet an obligation to convey resources; the lawsuit has not yet been lost) unless it is probable that a loss will occur. Liability; Wages Payable; current Liability; Bonds Payable; current No liability because the event causing responsibility for payment (the purchase) has not yet taken place 5. g 6. b 7. j 8. k 9.n 10. h 11. c 12. e 13. d 14. l

1. f 2. a 3. i 4. m a. b.

E9-12

A charter is the legal document granted by a state government that gives a corporation the right to exist. $760,000 Contributed capital is the total amount collected from stockholders from the sale of shares of stock. In this case, 80,000 shares were sold for a total of $760,000. (Acquisition of treasury stock neither increases nor decreases the amount of contributed capital.) $760,000 80,000 = $9.50 Outstanding shares is the number of shares held by stockholders. In this case, 80,000 were initially sold, but 1,000 have been reacquired. Only the par value of shares is recorded in the Common Stock account ($1 80,000 shares). The amount over and above par value is recorded in a second account with a title such as Paid-In Capital in Excess of Par Value. (Acquisition of treasury stock does not decrease the balance of the Common Stock account.) Authorized shares is the number permitted by the companys charter. Issued shares is the number that have been sold to investors.

c. d.

$9.50 79,000

e.

$80,000

E9-13

a. b.

1 million 255,000

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Chapter 9

c.

242,000

Outstanding shares is the number currently held by stockholders (255,000 13,000). Chips 2009 $ 125,000 a 9,875,000 b 325,000 d (390,000) e $9,935,000 $ 2008 125,000 9,875,000 75,000 0 $10,075,000 Company

E9-14 Quick Stockholders Equity Stockholders Equity: Common stock, $0.25 par value, 600,000 shares authorized, 500,000 shares issued Paid-in capital in excess of par Retained earnings Treasury stock, 15,000 shares Total stockholders equity
a b

b c

$0.25 500,000 = $125,000 ($20 500,000) $125,000 = $9,875,000 c ($100,000) + $250,000 $75,000 = $75,000 d $75,000 + $400,000 $150,000 = $325,000 e 15,000 $26 = $390,000 E9-15 a. Date of declaration: Date of record: Date of payment: 15.3% January 27 February 10 March 15

b. c.

$260,000 $1,700,000 = 15.3%

There are only two choices that a board of directors can make regarding profits. It can pay them out as dividends, or it can retain profits for reinvestment in the company (hence the term retained earnings). When a company chooses to pay out a relatively small portion of dividends, this is a signal to investors that the board of directors believes there are profitable opportunities within the firm for reinvestment of profits. When retained in the firm, profits can be used to finance growing sales levels (e.g., more inventory, more receivables, etc.), expand into new markets, or develop new products. If a company pays out most (or all) of its profits as dividends, this generally indicates that there are few good opportunities for earnings to be reinvested within the firm. Cash dividend: There is no effect on the income statement (dividends are a distribution of net income, not part of its computation). On the balance sheet, Cash and Retained Earnings decrease by $120,000 (60,000 shares $2). On the statement of cash flows, cash flow from financing activities decrease by $120,000. On the statement of stockholders equity, the retained earnings column decreases by $120,000.

E9-16

a.

Financing Activities

243

b.

Stock dividend: There is no effect on the income statement. On the balance sheet, Retained Earnings decreases by $21,000 and Contributed Capital increases by $21,000 (60,000 shares 5% $7 market price per share). There is no effect on the statement of cash flows. On the statement of stockholders equity, the retained earnings column is reduced by $21,000 and paid-in capital increases by $21,000. Specifically, Common Stock will go up by par value (60,000 5% $3 = $9,000), and Paid-In Capital in Excess of Par will go up by the remainder of $12,000. Stock split: There is no effect on the income statement. The only change on the balance sheet is under stockholders equity. The number of common shares authorized, issued, and outstanding are each doubled. The par value of the common shares is reduced from $3 to $1.50. There is no effect on the statement of cash flows. There is no effect on the statement of stockholders equity. $8,900,000 $700,000 common stock + $8,200,000 paid-in capital in excess of par value. 1,400,000 issued 60,000 treasury shares

c.

E9-17

a. b. c. d. e. f.

g. E9-18 a.

1,340,000 shares $480,000 Stock repurchased = $220,000 Stock issued = 100,000 shares ($50,000 $0.50) Dividends paid = $335,000 Cash flow: Paid for dividends $(335,000) Purchases of stock (220,000) Sale of stock 800,000 Net cash flow $245,000 As noted above, the source of the cash flow was the sale of stock. Net income from financing activities = $0. Financing activities do not create net income.

b. c. d.

e.

The increase in Retained Earnings was caused by the transfer of net income to Retained Earnings when the revenue and expense accounts were closed. The decrease in Retained Earnings was caused by the payment of dividends during the period. The decrease in Treasury Stock was caused by the sale of treasury stock to new stockholders. The increase in Common Stock was caused by the sale of new shares of common stock. The amount represents the par value of the new shares sold. The increase in Paid-In Capital in Excess of Par was caused by the same sale of new shares noted in part (d). The amount represents the amount collected over and above the par value of shares sold.

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E9-19 Year 2007 2008 2009 2010

a b

Total Dividends Paid $50,000 10,000 45,000 70,000

Dividends to Preferred $28,000a 10,000 45,000 29,000e

Dividends to Common $22,000b 0 0 41,000f

Unpaid Dividends to Preferred $ 0 18,000c 1,000d 0

4,000 $100 7% = $28,000 $50,000 $28,000 = $22,000 c $28,000 $10,000 = $18,000 d $18,000 + $28,000 $45,000 = $1,000 e $1,000 + $28,000 = $29,000 f $70,000 $29,000 = $41,000 E9-20 1. r 2. d 3. o 4. c a. b. c. d. 5. g 6. b 7. i 8. a 9.l 10. h 11. f 12. n 13. q 14. k 15. j 16. p 17. e 18. m

E9-21

50,000 400,000 $29.50

$2,500,000 preferred stock balance $50 par value per share $800,000 common stock balance $2 par value per share ($800,000 + $11,000,000) 400,000 shares

Preferred share = $4.00 $50 par value 8% = $4 Common share = $0.44 $376,000 $200,000 paid to preferred ($4 50,000 shares) = $176,000 available to common; $176,000 400,000 common shares = $0.44.

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245

PROBLEMS P9-1 A. B. C. D. $400,000 $384,440 8% 9% The cash amount paid each year divided by the face value of the bonds ($32,000 $400,000 = 8%). The amount of interest incurred in any year divided by its corresponding beginning-of-year present value. In year 1, for example, $34,600 $384,440 = 9%. The amount of interest incurred each year is reported on the income statement as interest expense. The present value at the end of any year is the amount reported on the balance sheet. For year 4 that amount is $396,330.

E. F.

$35,089 $396,330

G.

The total interest incurred, $175,560, is the total amount paid to creditors for the use of their funds over the five years. That total amount is paid out in pieces. First, an interest check is sent to creditors at the end of each of the five years. These payments total $160,000. The remaining $15,560, here labeled amortization of principal, is paid out at maturity of the bonds. On that date, the face value of the bonds is repaid to creditors ($400,000). Of that amount, $384,440 is repayment of the amount borrowed. The other $15,560 is for additional interest earned over the life of the bonds. The two interest payments total $175,560 ($160,000 + $15,560). 7% The bonds sold at a price of $310,394. This is a price above face value, so the stated rate is greater than the 6% effective rate. To determine the stated rate: Face value PV factor of single amount (4 periods, 6%) PV of the principal Price Less: PV of the principal PV of the annuity PV factor of annuity (4 periods, 6%) Annuity payment Annuity payment $ 21,000 Face value 300,000 Stated rate $ 0.07 $300,000 0.79209 $237,627 $310,394 237,627 $ 72,767 3.46511 $ 21,000

P9-2

A.

(continued)

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B.

An amortization table was not part of the requirements but is helpful to answer part B. B C Interest Incurred (B Interest Rate) 18,624 18,481 18,330 18,171 D Amount Paid 21,000 21,000 21,000 21,000 E Amortization of Principal (C D) (2,376) (2,519) (2,670) (2,829)* F Value at End of the Year (B + E) 308,018 305,499 302,829 300,000

Year 1 2 3 4

Present Value at Beginning of Year 310,394 308,018 305,499 302,829

*Difference due to rounding. The necessary entries to the accounting system are as follows: At date of issuance
Account Cash Bonds Payable Debit 310,394 310,394 Credit A +310,394 +310,394 = L+ OE CC + RE

At date of first interest payment

Account Interest Expense Bonds Payable Cash Debit 18,624 2,376 21,000 21,000 Credit A = L+ 2,376 OE CC + RE 18,624

At date of last interest payment

Account Interest Expense Bonds Payable Cash Bonds Payable Cash Debit 18,171 2,829 21,000 300,000 300,000 300,000 21,000 300,000 Credit A = L+ 2,829 OE CC + RE 18,171

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247

P9-3

A.

$9,304,891 (1) Interest payments = 8% $9 million = $720,000 Maturity value = $9 million (2) PV of interest = $720,000 3.38721 = PV of maturity = $9 million 0.76290 = Price of bonds $2,438,791 6,866,100 $9,304,891 F Value At End of Period (B + E) 9,236,233 9,162,769 9,084,163 9,000,000

B. A B C Present Value at Be- Effective Inginning of terest Period (B 0.07) 9,304,891 651,342 9,236,233 646,536 9,162,769 641,394 9,084,163 635,837* D Interest Payment @ 0.08 720,000 720,000 720,000 720,000 E Amortization of Principal (C D) (68,658) (73,464) (78,606) (84,163)

Period 1 2 3 4

*Adjusted for rounding difference. Observe that the liability decreases each year until the maturity value is reached at the end of year 4. C.
Account Interest Expense Bonds Payable Cash Debit 651,342 68,658 720,000 720,000 Credit A = L+ 68,658 OE CC + RE 651,342

D.

$8,708,468

PV of interest = $720,000 3.23972 = PV of principal = $9,000,000 0.70843 = (1) Interest payments = 9% $10 million = Maturity value = $10 million

$2,332,598 6,375,870 $8,708,468 $900,000

P9-4 A.

$9,682,983

(2) PV of interest = $900,000 3.16987 = $2,852,883 PV of maturity = $10 million 0.68301 = 6,830,100 Price of bonds $9,682,983 (continued)

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B. A

The amortization schedule would show the following:

B C D E F Present Value Value at Effective Interest Amortization at End of Beginning Interest Payment of Principal Period Period of Period (B 0.10) @ 0.09 (C D) (B + E) 1 9,682,983 968,298 900,000 68,298 9,751,281 2 9,751,281 975,128 900,000 75,128 9,826,409 3 9,826,409 982,641 900,000 82,641 9,909,050 4 9,909,050 990,950* 900,000 90,950 10,000,000 *Adjusted for rounding difference. Observe that the liability increases each year until the maturity value is reached at the end of year 4. C.
Account Interest Expense Bonds Payable Cash Debit 968,298 68,298 900,000 +68,298 900,000 Credit A = L+ OE CC + RE 968,298

D.

$10,331,217

PV of interest = $900,000 3.31213 = $ 2,980,917 PV of principal = $10,000,000 0.73503 = 7,350,300 $10,331,217

P9-5 The price of a 10-year bond paying 8% interest, with semiannual payments, and yielding a 6% market rate would be $1,149 [($40 14.87747) + ($1,000 0.55368) = $1,149]. The bonds sold by Ethan, having these same terms, were selling for $1,350. Therefore, the bonds sold by Ethan were yielding a market rate of less than 6%, less than the yield on similar bonds investors could have purchased. Investors had a right to be concerned about their investments because they expected to earn a return of 8%. Their actual yield was much lower because the bonds sold at a premium. An ethical problem exists because Ethan had taken advantage of the investors lack of understanding of bond yields. His sales pitch compared nominal and market rates of interest, which the investors did not understand. He led them to believe they were getting a good deal. In fact, the bonds they purchased paid a lower market return than they could have obtained from other investments of the same type. Ethan was taking advantage of the investors lack of knowledge about bonds for personal gain.

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249

P9-6

A.

Option #1 annual payment is $14,761 PVA = Amount of annuity IF (Table 4) $50,000 = Amount 3.38721 Amount = $50,000 3.38721 = $14,761 Option #2 annual interest expense is $3,500 ($50,000 0.07)

B. Total Cash Outflow Option #1 Option #2

a b

Total Interest Expense $ 9,044b 14,000d

$59,044a 64,000c

Annual payment of $14,761 4 years Total cash outflow less principal ($59,044 $50,000) c Total interest plus principal ($50,000 + $14,000) d Total interest paid ($3,500 4 years) C. The firm would pay more under option 2 because no principal is repaid until the end of the four years. Hence, the entire balance is outstanding and incurring interest for the entire four-year period. Under option 1, however, some principal is repaid each year so that interest is incurred on smaller and smaller amounts of remaining principal each year. The better choice would depend on the firms cash position. If there is currently a shortage of cash, it might choose option 2, requiring only a $3,500 payment instead of one for $14,761 for each of the first three years. The choice of option 2 would presume that the firms cash position will improve sufficiently over the four-year period so that the final payment of $53,500 ($50,000 + $3,500) can be made. If the firm estimates it will be able to meet the $14,761 payment at the end of the first year, option 1 would save $4,956 in interest ($64,000 $59,044). Dealer A: $271,736 Because the present value of an annuity is known ($2 million), the annual payments can be determined. PVA = Amount of annuity IF (Table 4, 10 periods, 6%) $2,000,000 = Amount 7.36009 Amount = $2,000,000 7.36009 = $271,736

D.

P9-7

A.

B.

PVA = Amount of annuity IF (Table 4,10 periods, 8%) $1,800,000 = Amount 6.71008 Amount = $1,800,000 6.71008 = $268,253 Dealer A Dealer B Payments to Dealer A (10 $271,736) $2,717,360 Payments to Dealer B (10 $268,253) $2,682,530 Installation cost 50,000 Projected cash outflow $2,717,360 $2,732,530 Dealer B: $268,253

250

Chapter 9

C.

Total of payments Less: cash price Interest savings from paying cash

$2,717,360 2,000,000 1,800,000 $ 717,360

$2,682,530 $ 882,530

D.

If the company will finance the equipment, it should accept Dealer As financing terms because it will save $15,170 ($2,732,530 $2,717,360) over Dealer Bs offer. However, if the company chooses to pay cash it will save $150,000 by accepting Dealer Bs offer ($2,000,000 $1,850,000). A cash outflow will appear in the financing section each year for 10 years. Only the portion of each payment that reduces the Capital Lease Obligation is a financing activity. Interest is shown in the operating activities section.

E.

P9-8

A. B. A

$175,438

$24,500 7.16073 (Table 4, 12 periods, 9%) = $175,438 C Interest Incurred (B Interest Rate) 15,789 15,005 14,151 13,219 D E Amortization of Principal (C D) (8,711) (9,495) (10,349) (11,281) F Value at End of the Year (B + E) 166,727 157,232 146,883 135,602

Year 1 2 3 4 C.

B Present Value at Beginning of Year 175,438 166,727 157,232 146,883

Amount Paid 24,500 24,500 24,500 24,500

D.

The lease transaction is being used as a method of financing acquisition of the asset. Therefore, every lease payment is part interest and part reduction of the amount owed (principal) for purchase of the asset. Each period, the interest incurred on the unpaid balance is deducted from the $24,500 payment and the remaining amount is applied to reducing the amount owed. As each payment is made, the amount owed decreases. As the unpaid balance decreases, the amount of interest expense on the unpaid balance also decreases. This leaves a larger portion of each successive payment to go toward reduction of the amount owed (principal).

Financing Activities

251

E.
Account Bulldozer Capital Lease Obligation Debit 175,438 175,438 Credit A +175,438 +175,438 OE CC + RE 15,789 = L+ OE CC + RE

F.
Account Interest Expense Capital Lease Obligation Cash Debit 15,789 8,711 24,500 24,500 8,711 Credit A = L+

P9-9

A.

$15,259

Three tractors with a total cost of $123,000 ($41,000 3) are being financed with the lease. $123,000 is the present value of the lease payments. Therefore, $123,000 = Payments 8.06069 (Table 4, 15 periods, 9%), or $123,000 8.06069 = $15,259. The cost of the tractors is $123,000. This is also the amount that is to be financed with the lease. This is the amount owed and, therefore, the amount of the lease obligation. Because there is no down payment, the cost of the tractors is also the present value of the lease payments necessary to retire the debt.
Debit 123,000 123,000 Credit A +123,000 +123,000 = L+ OE CC + RE

B.

$123,000

C.
Account Tractors Capital Lease Obligation

D.

$105,885

The sum of the payments is $228,885 (15 years $15,259). The cost of the tractors is $123,000 ($41,000 3). The difference between the total amount paid and the price of the tractors is the amount paid for financing the transaction. ($228,885 $123,000 = $105,885)
Debit Credit A = L+ OE CC + RE 11,070

E.
Account Interest Expense 11,070 Capital Lease Obligation 4,189* Cash 15,259 15,259 *123,000 9% = $11,070; $15,259 $11,070 = $4,189

4,189

(continued)

252

Chapter 9

F.

Smaller. Each year, the amount being financed (the lease obligation) decreases. As the amount being financed decreases, the cost of financing it also decreases. $153,852 Rate = 0.008125 (0.0975 12) Periods = 60 Payment = $3,250 Excel formula = PV(0.0975/12,60,3250)
OE CC + RE

P9-10

A.

Arguments:

B.
Account Leased Equipment Capital Lease Obligation Debit 153,852 153,852 Credit A +153,852 +153,852 = L+

C. B Present Value at Beginning of Period Period 1 153,852 2 151,852 3 149,836 4 147,803 D.

Account Interest Expense Capital Lease Obligation Cash Debit 1,250 2,000 3,250 3,250 2,000 Credit A = L+ OE CC + RE 1,250

C Interest Incurred (Column B 0.8125%) 1,250 1,234 1,217 1,201

D Amount Paid 3,250 3,250 3,250 3,250

E Amortization of Principal (Column C Column D) (2,000) (2,016) (2,033) (2,049)

F Value At End of Period (B + E) 151,852 149,836 147,803 145,754

E.

At inception of the lease, the required monthly payments have a present value of $153,852. This is, in effect, the selling price of the equipment and the amount financed by the seller. The amortization table shows that, for each month, the interest expense incurred by the purchaser is exactly equal to 0.8125% of the amount owed (9% interest 12 months = 0.8125%). For example, in period one, the purchaser owes a balance of $153,852 for the entire month. At 9% annual interest (or interest of 0.8125% per month), this results in interest expense of $1,250. This amount is paid to the seller at the end of the first period along with another $2,000, which reduces principal. Therefore, in each month the seller is earning 0.8125% interest on the unpaid balance, which adds up to a 9% annual rate.

Financing Activities

253

P9-11 A. B.

$95,535

= PMT(0.1135,5,350000)
OE CC + RE

Account Leased Equipment Capital Lease Obligation

Debit 350,000

Credit

A +350,000

L+

350,000

+350,000

C. A B Present Value at Beginning of Period 350,000 294,190 232,046 162,848 85,796 C Interest Incurred (Column B 11.35%) 39,725 33,391 26,337 18,483 9,738 D Amount Paid 95,535 95,535 95,535 95,535 95,535 E Amortization of Principal (Column C Column D) (55,810) (62,144) (69,198) (77,052) (85,797) F Value At End of Period (B + E) 294,190 232,046 162,848 85,796 0*

Period 1 2 3 4 5 D.

*Ignore $1 rounding error.

The interest expense (column C above) decreases each year because the amount owed decreases each year. As the years go by, the purchaser is financing a smaller and smaller amount. Therefore, the interest expense decreases.
OE CC + RE 39,725

E.
Account Interest Expense Capital Lease Obligation Cash Debit 39,725 55,810 95,535 95,535 55,810 Credit A = L+

F.

At inception of the lease, the required payments have a present value of $350,000. This is the selling price of the equipment and the amount financed by the seller. The amortization table shows that, each year, the interest expense incurred by the purchaser is exactly 11.35%. For example, during the first year, the purchaser owes a balance of $350,000 for the entire year. An 11.35% annual interest rate results in interest expense of $39,725. This amount is paid to the seller at the end of the first period along with another $55,810, which reduces principal. Therefore, in each year the seller is earning 11.35% interest on the unpaid balance.

254

Chapter 9

P9-12

A.

The Stockholders' Equity section at December 31, 2008, would report: Common stock, $2 par value, 5,400,000 shares authorized, 2,417,000 shares issued, 2,387,000 shares outstanding1 $ 4,834,000 Paid-in capital in excess of par 35,791,000 Retained earnings2 34,420,200 Treasury stock (at cost, $21) (630,000) Total stockholders' equity $74,415,200
1

The number of shares outstanding after the above transactions would be: Number at beginning of year Treasury shares purchased 10% stock dividend* 217,000 Number at end of year 2,387,000 2,200,000 (30,000)

*Stock dividend = 217,000 shares [(2,200,000 30,000 treasury shares) 10%] Reduction in Retained Earnings = 217,000 $25 market price = $5,425,000 Increase in Common Stock = 217,000 $2 par = $434,000 Increase in Paid-In Capital in Excess of Par = $5,425,000 $434,000 = $4,991,000
2

The value of Retained Earnings after these transactions is: Beginning balance $46,000,000 Net loss (5,200,000) Stock dividend (5,425,000) Cash dividend (954,800) Ending balance $34,420,200

Financing Activities

255

B.

The financing section of the Statement of Cash Flows would report the following: 1) Purchase of treasury stock (630,000) 2) Payment of cash dividends (954,800) (1,584,800) The Stockholders' Equity section of the Balance Sheet after the stock split would be: Common stock, $1 par, 600,000 shares authorized, 400,000 shares issued and outstanding $ 400,000 Additional paid-in capital in excess of par 1,500,000 Retained earnings 3,600,000 Total $5,500,000 Stockholders will receive 200,000 additional shares, one share for each share previously held. The market value of the stock on the date of the split is not applicable.

P9-13

A.

B.

The Stockholders Equity section of the Balance Sheet after the 100% stock dividend would be: Common stock, $2 par, 600,000 shares authorized 400,000 shares issued and outstanding $ 800,000 Additional paid-in capital in excess of par 1,500,000 Retained earnings 3,200,000 Total $5,500,000 Again, stockholders will receive 200,000 additional shares, one share for each share held. The par value times the number of shares ($2 200,000) reduces Retained Earnings and increases Common Stock.

C.

The total of stockholders equity is the same whether the company carries out a split or a dividend. For the split, par is decreased from $2 to $1, and the number of shares issued is doubled from 200,000 to 400,000. Thus, the common stock account balance is $400,000 ($1 400,000) shares. Thus, no account changes in amount. For the 100% stock dividend, par per share remains at $2, but the total in the common stock account is doubled, to $800,000. The $400,000 increase comes from Retained Earnings, which decreases from $3,600,000 to $3,200,000. In essence, a stock dividend increases Contributed Capital and decreases earned capital (Retained Earnings).

D.

The market price of the stock after both the stock split and the stock dividend should be about $9 per share: $18 2 = $9.

256

Chapter 9

P9-14

A.

Net income = $26,182. Net income is reported on the bottom of the income statement. It also appears on the statement of cash flows when the indirect format is used. There, it appears as the first line of the operating activities section. Dividends = $14,300. The dividends reported here must be cash dividends because there was no offsetting entry to increase paid-in capital. Cash dividends are reported on the statement of cash flows under the category of financing activities. Dividends reduce cash flow from financing activities. Treasury stock increase = $1,263. The acquisition of treasury stock is also reported on the cash flow statement. It is reported under the category of financing activities and reduces cash flow. (continued) Stock issued = $79,000. An issuance of stock is reported on the statement of cash flows under the financing activities section. It increases cash flow from financing activities. Common stock = $14,000. The cumulative par value of all common stock issued to date is reported on the balance sheet under the stockholders equity section. Stockholders Equity Before Conversion Preferred stock, $5 par, 4,000 shares outstanding Additional paid-in capital, Preferred stock Common stock, $1 par, 45,000 shares outstanding Additional paid-in capital, Common stock Retained earnings Total 20,000 28,000 45,000 1,305,000 3,200,000 $4,598,000 $

B.

C.

D.

E.

P9-15

A.

B.

Stockholders Equity After Conversion Common stock, $1 par, 57,000 shares outstanding Additional paid-in capital, Common stock Retained earnings Total $ 57,000 1,341,000 3,200,000 $4,598,000

The total in the preferred stock accounts was $20,000 + $28,000 or $48,000. For the conversion, 3 4,000 or 12,000 new shares of common stock at $1 par would be issued. This would increase the common stock account by $12,000 to $57,000 ($12,000 + $45,000). The additional paid-in capital account for common stock would increase by $36,000 ($48,000 $12,000) to $1,341,000. The total of the Stockholders' Equity section is the same before and after the conversion. As mentioned in the problem, no cash changes

Financing Activities

257

hands. The preferred stock is merely exchanged for shares of common stock. The current fair market value of the common stock is not relevant. C. D. There is no effect on the financing section of the Statement of Cash Flows. Shareholders are often attracted by convertible preferred stock. So, they may be willing to accept a lower dividend rate than other, similar investments for the privilege of converting their preferred stock into common stock. In this problem, shareholders of the Neese Company are willing to accept a $0.50 dividend on preferred stock, while shareholders of the Velasquez Corporation receive a dividend of $1.60 on their nonconvertible preferred stock.

258

Chapter 9

P9-16 The complete stockholders equity section is as follows: December 31 Stockholders Equity 8.5% Preferred stock, $10 par value, 10,000 shares authorized and issued Common stock, $2 par value, 300,000 shares authorized, 110,000 and 90,000 shares issued Paid-in capital in excess of par value Retained earnings Treasury stock (4,500 and 3,100 shares at cost) Total Stockholders Equity 2008 $ 100,000b 220,000 960,000 192,500
d f h

2007 $ 100,000a 180,000 c 720,000e 75,000g (37,200)i $1,037,800

(60,750)j $1,411,750

The individual items can be determined as follows: a. b. c. d. e. f. g. 10,000 preferred shares $10 par value 10,000 preferred shares $10 par value 90,000 common shares $2 par value 110,000 common shares $2 par value This number is a plug after all other 2007 numbers are determined. This number is calculated after all other 2008 numbers are determined. Equal to net income of 2007. Because the dividend payment date is April 1, the first opportunity to distribute 10% of 2007s profit will be April 1, 2008. h. Equal to the sum of both years net income ($75,000 + $125,000 = $200,000) minus the dividend paid on April 1, 2008 ($75,000 10% = $7,500). Therefore, the ending balance of retained earnings at December 31, 2008, is $192,500 ($200,000 $7,500). i. These treasury shares were acquired at a cost of $12 each. 3,100 shares $12 = $37,200. Treasury stock is a deduction from stockholders equity. j. The average price of the 4,500 treasury shares was $13.50. 4,500 shares $13.50 = $60,750. P9-17 A. B. 3,000 60,000 shares (2007) 75,000 shares (2008) C. 2,450 shares (2007) 1,400 shares (2008) $300,000 $100 par value = 3,000 preferred shares issued; same answer for both years $120,000 $2 par value = 60,000 common shares issued $150,000 $2 par value = 75,000 common shares issued $25,725 $10.50 average price = 2,450 treasury shares $16,800 $12 average price = 1,400 treasury shares

Financing Activities

259

D.

57,550 (2007) 73,600 (2008)

60,000 shares issued 2,450 treasury shares = 57,550 75,000 shares issued 1,400 treasury shares = 73,600 Common stock account balance ($120,000) + paid-in capital account balance ($620,000) divided by number of issued shares (60,000) = $740,000 60,000 = $12.33 Increase in the common stock account balance ($30,000) + the increase in the paid-in capital account ($210,000) divided by the change in the number of shares outstanding (15,000 shares) = $240,000 15,000 = $16.00 The company was started during 2007. Dividends are declared 30 days after the end of the year. Therefore, no dividends have yet been declared at December 31, 2007. The years ending Retained Earnings balance must be equal to 2007s net income. 2008s net income is equal to the change in year-end Retained Earnings + dividends paid during 2008. The change in Retained Earnings is $205,000 ($362,500 $157,500). Dividends paid in 2008 equal $15,750 (10% of 2007s net income of $157,500). Therefore, 2008s net income is $220,750 ($205,000 + 15,750). The preferred stock earns a dividend of $7.00 per year (7% $100 par value). With 3,000 shares outstanding this requires total dividends of $21,000. On March 1, 2008, however, the firm paid dividends totaling only $15,750. The entire amount goes to the preferred shareholders at $5.25 per share ($15,750 3,000 shares). All dividends due to preferred stock must be paid before any dividends may be paid to common. No dividends could be paid to common stockholders in 2008.

E.

$12.33

F.

$16.00

G.

$157,500 (2007)

$220,750 (2008)

H.

$5.25

I.

zero

260

Chapter 9

J.

zero

The preferred stock is cumulative. No dividends can be paid to common until all prior years preferred dividends have been paid and the 2009 preferred dividend is paid in full. Preferred stockholders are still owed $5,250 from 2008 ($21,000 was owed; $15,750 was paid). In addition, the 2009 preferred dividend is $21,000. Dividends totaling only $22,075 (10% 2008s net income of $220,750) are scheduled for payment on March 1, 2009. That entire amount must go to preferred shareholders. $450,000 $25 par value $375,000 $25 par value $680,000 $5 par value $575,000 $5 par value $1,970,050 $31 average cost $1,510,000 $25 average cost 136,000 issued 63,550 treasury shares 115,000 issued 60,400 treasury shares

P9-18

A. B. C. D.

2008: 18,000 preferred shares 2007: 15,000 preferred shares 2008: 136,000 common shares 2007: 115,000 common shares 2008: 63,550 treasury shares 2007: 60,400 treasury shares 2008: 72,450 shares outstanding 2007: 54,600 shares outstanding

E. F.

$34.78 $78.81

($680,000 + $4,050,000) 136,000 shares 2008: $680,000 + $4,050,000 = $4,730,000 2007: $575,000 + $2,500,000 = 3,075,000 Proceeds from 2008 stock sale $1,655,000 $1,655,000 21,000 new shares = $78.81 Net income is the change in Retained Earnings + the dividends distributed in 2008. 2008 Retained Earnings $9,400,300 2007 Retained Earnings 7,300,800 Change in retained earnings $2,099,500 Add: 2008 dividends (25% of Year 2007 net income of $2.0 million) 500,000 2008 income $2,599,500 $25 par value 8.5% = $2.125 (continued)

G.

$2,599,500

H.

$2.125

Financing Activities

261

I.

$8.46

Total dividends in 2008 Less: preferred dividends ($2.125 18,000 shares) Dividends available to common Divided by 54,600 common shares Dividend per common share 2008 net income Portion available for dividends Total dividends in 2009 Less: preferred dividends in 2009 Dividends available to common Divided by 72,450 common shares Dividend per common share

$500,000 38,250 $461,750 54,600 $ 8.46 $2,599,500 25% $ 649,875 38,250 $ 611,625 72,450 $ 8.44

J.

$8.44

P9-19 A. B

C.

D.

E.

F.

G. H. I.

J.

Yes; generally companies will record an estimate of the liability to repair potential defective products. No; the estimate of uncollectible accounts would not be recorded as a liability; the company has no future obligation once a sale has been made, except possibly for repairs. The estimate of uncollectible accounts would be recorded as an expense. No; since the company will be using the asset for only about onethird of its useful life, the transaction is not really a purchase. A liability should not be recorded; this is likely an operating lease. This is a judgment call. If it is believed that the company will indeed be held responsible and the amount can be estimated, a liability probably should be recorded. Otherwise, a contingency would be disclosed in the notes. Yes; as long as the bonds have not been redeemed, they should be shown as a liability. This would be a current liability, so the company would be required to transfer the amount from the long-term section of the balance sheet to the short-term section. No; the case has not yet been decided, so no liability exists. The company should probably disclose that it has been sued, but this would not affect the balance sheet. No; stock dividends do not require the use of a company's assets, so no liability should be recorded. Yes; cash dividends result in a liability as soon as they are declared. This will likely be a current liability. No; there is no liability for a cash dividend until it is declared, even though the company may be in arrears with dividend payments. The company may want to disclose the fact, however, to inform the common stockholders. Maybe. Some companies report noncontrolling interest as a liability, whereas others report it as part of equity.

262

Chapter 9

K. L. P9-20

Yes; the company will continue to report the bonds as a liability even though the conversion to common stock may be likely. No; stock options affect the owners' equity section of the balance sheet.

Maturity Interest Payments Actual Interest Rate Periods Present Value of Interest Present Value of Principal Total Present Value Present Value at Beginning of Month 1,954,505.76 1,954,571.74 1,954,638.23 1,954,705.23 1,954,772.75 1,954,840.79 1,954,909.35 1,954,978.44 1,955,048.07

$2,000,000 Total interest expense in 2008 = $135,612.47 $15,000.00 Total interest paid in 2008 = $135,000.00 0.007708333 Total liability on 12/31/08 = $1,955,118.23 240 $1,637,792.68 $316,713.07 $1,954,505.76

Month 1 2 3 4 5 6 7 8 9 Total

Interest Incurred 15,065.98 15,066.49 15,067.00 15,067.52 15,068.04 15,068.56 15,069.09 15,069.63 15,070.16 135,612.47

Amount Paid 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 135,000.00

Amortization of Principal 65.98 66.49 67.00 67.52 68.04 68.56 69.09 69.63 70.16 612.47

Value at End of Month 1,954,571.74 1,954,638.23 1,954,705.23 1,954,772.75 1,954,840.79 1,954,909.35 1,954,978.44 1,955,048.07 1,955,118.23

Note: Students may observe slight rounding errors between their solutions and the solutions presented here. Rounding errors typically occur because of the number of significant digits Excel uses in its calculations. Maturity $2,000,000 If the effective interest rate were 8.75%: Interest Payments $15,000.00 Total interest expense for 2008 = $134,324.74 Actual Interest Rate 0.007291667 Periods 240 Present Value of Interest $1,697,388.05 Present Value of Principal $349,761.61 Total Present Value $2,047,149.67

Financing Activities Present Value at Beginning of Month 2,047,149.67 2,047,076.80 2,047,003.40 2,046,929.47 2,046,855.00 2,046,779.98 2,046,704.42 2,046,628.31 2,046,551.64

263

Month 1 2 3 4 5 6 7 8 9 Total

Interest Incurred 14,927.13 14,926.60 14,926.07 14,925.53 14,924.98 14,924.44 14,923.89 14,923.33 14,922.77 134,324.74

Amount Paid 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 135,000.00

Amortization of Principal (72.87) (73.40) (73.93) (74.47) (75.02) (75.56) (76.11) (76.67) (77.23) (675.26)

Value at End of Month 2,047,076.80 2,047,003.40 2,046,929.47 2,046,855.00 2,046,779.98 2,046,704.42 2,046,628.31 2,046,551.64 2,046,474.41

Maturity $2,000,000 If the effective interest rate were 9%: Interest Payments $15,000.00 Total interest expense for 2008 = $135,000.00 Actual Interest Rate 0.0075 Periods 240 Present Value of Interest $1,667,174.31 Present Value of Principal $332,825.69 Total Present Value $2,000,000.00 Present Value at Beginning of Month 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00

Month 1 2 3 4 5 6 7 8 9 Total

Interest Incurred 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 135,000.00

Amount Paid 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 15,000.00 135,000.00

Amortization of Principal

Value at End of Month 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00 2,000,000.00

P9-21 1 a 2 a 3 b 4 c 5 c 6 d 7 c 8 b 9 a 10 a

264

Chapter 9

CASES C9-1 Information that might be helpful in making a loan decision would include the following: A description of the company: A borrower should describe the business, its products, its locations, and any special features that are important for understanding its performance. Key suppliers, customers, managers or employees, and other contractual relationships should be described. This information helps creditors determine the objectives of a company and factors that might be important to its success. It also may identify important risks, such as dependency on a particular customer or supplier. Financial statements for the business for the past several years: A creditor is interested in whether a borrower is likely to pay interest and principal at the agreed times. The ability of a borrower to make these payments depends largely on cash flows from operating activities. Financial statements provide information about accrual and cash flow basis results of operating activities. These results are an indication of a companys success in meeting its cash flow needs. Trends and variations in operating results over time can be a useful indicator of future success or failure. A balance sheet is useful for assessing the amount of debt a company has outstanding and the demands on its cash flows associated with this debt. A balance sheet also can help identify assets that could be used to repay debt if a company defaults on its debt or is forced to liquidate. A plan describing future activities and use of borrowed funds: In addition to historical statements, information about expected future activities is important to determine how a loan will be used. A borrower should demonstrate a need for the funds and a well-conceived strategy for employing the funds. A description of how the funds will be used and the expected effect of the funds on future operating results can help in assessing the likely success of the endeavor. A cash flow plan demonstrating how a company expects to meet its cash flow needs can be especially helpful. This type of information indicates that a borrower has thought about the project and its implications for the companys future success. C9-2 A. The par value of a companys stock represents the portion of contributed capital that may be legally restricted. In some states, corporations are not permitted to pay out the par value of their stock as dividends. Instead, the amount of par value must be maintained in the corporation. The decision by this company to restate the par value of its stock signals a financial problem. By restating the par value of its stock, the company is freeing up contributed capital that can be paid out as a dividend. The company has shifted a portion of

Financing Activities

265

contributed capital from the par value category (no dividends permitted) to the paid-in capital in excess of par category (dividends can be paid). If dividends are paid, they will probably be paid to the preferred stockholders to cover the arrearage and future dividend requirements. B. Preferred stock typically has a fixed dividend rate. If the stock is cumulative, dividends in arrears must be paid before dividends can be paid to common stockholders. Preferred stockholders usually do not have voting rights. Like common stock, preferred stock does not have a fixed maturity. Preferred dividends are not deductible for tax purposes. Like debt, preferred stock carries a fixed return and does not have voting rights. Also, it has a higher claim to payments than does common stock. Companies issue preferred stock to provide another source of capital. Preferred stock appeals to some investors who want higher potential returns than those provided by debt securities but do not wish to take the risk associated with common stock. Suspension of preferred dividends has no effect on the financial statements. No account balances are affected directly by the decision. The decision affects the future ability of the company to pay dividends to common stockholders. Thus, the company has an economic obligation to pay the dividends at some point in the future if it is to continue as a viable going concern. If the preferred stock and dividends in arrears were reported as liabilities, the companys balance sheet would appear as follows: December 31 (Millions) Total assets Total liabilities (including preferred stock and dividends) Stockholders equity Total liabilities and stockholders equity 2007 $3,759.7 $3,250.9 508.8 $3,759.7 2006 $3,774.4 $3,502.7 271.7 $3,774.4

C.

A large portion of the companys stockholders equity would be eliminated if the preferred stock were reported as a liability. D. The common stockholders have only a small claim to the companys future cash flows and earnings. This claim increased in 2007, however, because of the success of the company in increasing its retained earnings from profits earned during the year. At year-end 2007, the common stockholders equity is only $562.7 million ($1,347.8 $785.1). This is up from $333.1 million in 2006 ($1,122.1 $789.0). At the end of 2007, the company could conceivably pay out a maximum of $79.9 million in dividends because this is the balance of Retained Earningsif it had enough cash. Of that amount, however, the first $53.9 million would go to the preferred shareholders to make up dividends in arrears.

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Chapter 9

C9-3

A.

At year-end 2004, liabilities are a primary source of financing for assets. At that date, 70% of the companys assets were financed with liabilities. The most significant liability was long-term debt of $7,643 million (7,410 + 233), which comprises 59% of the firms liabilities. Significant financing cash flows related to liabilities include changes (reductions) in notes payable and long-term debt of $1,023 million and $248 million, respectively. The major change from 2001 to 2004 was the increase in common stock. The company issued shares in connection with the Pillsbury acquisition. A substantial amount of treasury stock was also purchased during 2002.

B. C.

D.