CHAPTER 11 LONG-TERM LIABILITIES: NOTES, BONDS, AND LEASES 9 Financing Decisions... · LONG-TERM LIABILITIES: NOTES, BONDS, AND LEASES ... During 2009 $9.375 million of interest expense

CHAPTER 11

LONG-TERM LIABILITIES: NOTES, BONDS, AND LEASES

BRIEF EXERCISES

BE11–1

a. During 2009 Radio Shack paid down $43.2 million of notes payable (long-term debt) and $2.3 million of other long-term debt. Further, the reduction in the unamortized discount reflects the fact that interest expense was booked at the effective rate while cash paid for interest was calculated at the stated rate of interest. When the debt obligations were repaid, the balance sheet and the statement of cash flows were adjusted. Interest expense affects the income statement.

b. During 2009 $9.375 million of interest expense was recognized on the 2.5% notes (2.5% x $375

million). c. If Radio Shack paid $300 million to retire the notes in 2009 the company would have recorded a

gain of $6.8 million on the transaction. ($306.8 – $300). This amount would be found on the income statement as a gain on the early extinguishment of debt.

BE11–2

a. The life of these bonds is 20 years, from 1997 until 2017. b. The stated interest rate is 0%. c. The effective rate is 3.2%. (The present value is $968 million, while the future value of the single

sum in 20 years is $1.8 billion.) d. Bonds typically are issued in amounts of $1,000, therefore Hewlett-Packard issued 1.8 million

bonds with a total face value of $1.8 billion.

EXERCISES

E11–3

1 Par value

2 Discount

3 Premium

4 Premium

E11–4

Present Value = Present Value of Face Value + Present Value of Interest Payments

Note 1

Present Value = ($1,000 Present Value Factor for i = 8% and n = 4) + [($1,000 0%)

Present Value of an Ordinary Annuity Factor for i = 8% and n = 4]

= $1,000 .7350 (from Table 4 in Appendix A) + $0

= $735.00

Note 2



= $5,000 .7050 (from Table 4 in Appendix A) + $0

= $3,525.00

Note 3



= ($8,000 .5066 (from Table 4 in Appendix A) + ($320 4.1114 (from

Table 5 in Appendix A)

= $4,052.80 + $1,315.65

= $5,368.45

Note 4

Present Value = ($3,000 Present Value Factor for i = 8 % and n = 7) + [($3,000 8%)


= ($3,000 .5835 (from Table 4 in Appendix A) + ($240 5.2064)

(from Table 5 in Appendix A)

= $1,750.50 + $1,249.54

= $3,000.00

Note 5

Present Value = ($10,000 Present Value Factor for i = 6 % and n = 10) + [($10,000

10%) Present Value of an Ordinary Annuity Factor for i = 6% and n = 10]

= ($10,000 .5584 (from Table 4 in Appendix A) + ($1,000

7.3601 (from Table 5 in Appendix A)

= $5,584.00 + $7,360.10

= $12,944.10

E11–5

a. Present Value = Present Value of Face Value + Present Value of Interest Payments

$11,348 = ($20,000 Present Value Factor for i = ? and n = 5) +

[($20,000 0%) Present value of an ordinary annuity factor for i = ? and n = 5]

= ($20,000 Present Value Factor) + $0 Present Value Factor = 0.5674

Looking in the n = 5 row of Table 4 in Appendix A reveals that a present value factor of 0.5674 corresponds to an annual effective interest rate of 12%.

b. Equipment (+A) ................................................................................ 11,348 Discount on Notes Payable (–L) ...................................................... 8,652 Notes Payable (+L) .................................................................... 20,000 Purchased equipment by issuing a note.

c. Interest Expense = Book Value of Debt Effective Interest Rate

= ($20,000 – $8,652) 12% = $1,361.76 d. Balance Sheet Value = Face Value of Note – Discount on Notes Payable = $20,000.00 – ($8,652.00 – $1,361.76) = $12,709.76

e. Interest expense is computed as the debt's book value times the effective interest rate. For a note issued at a discount, the book value will increase over time until the book value equals the face value immediately prior to the note maturing. Since the book value is greater at the beginning of Year 2 than it was at the beginning of Year 1, and the effective interest rate is constant, the interest expense recognized by Tradewell in the second year will be greater than the interest expense recognized in the first year.

Intuitively this makes sense. During Year 1, Tradewell only "borrowed" $11,348. Although

Tradewell has to compensate the creditor for using the creditor's money during Year 1, Tradewell did not make any such payment to the creditor during Year 1 because the stated rate on the note is 0%. Thus, the amount that Tradewell should have compensated the creditor (i.e., interest expense) is simply added on to what Tradewell "borrowed" from the creditor. During

Year 2, therefore, Tradewell has to pay interest not only on the initial $11,348 it "borrowed," but also on the interest that it incurred, but did not pay, during Year 1.

As proof, Interest Expense for Year 2 = $12,709.76 [from part (d)] 12%

= $1,525.17

This amount exceeds the interest expense for Year 1 computed in part (c).

f. Since the note has not yet matured, the same logic used in part (e) can be applied to this question. Consequently, the interest expense recognized by Tradewell in the third year will be greater than the interest expense recognized in the second year.

As proof, Interest Expense for Year 3 = Book Value at Beginning of Year 3 12%

= [$20,000.00 – ($8,652.00 – $1,361.76 –

$1,525.17)] 12%

= $1,708.19

This amount exceeds the interest expense for Year 2 computed in part (e).

E11–6

a. Stated interest rate = 8% Cash (+A) ......................................................................................... 8,000 Notes Payable (+L) .................................................................... 8,000 Issued notes payable. Interest Expense (E, –SE) ............................................................... 640 Cash (–A) ................................................................................... 640 Incurred and paid interest. Interest Expense (E, –SE) ............................................................... 640 Cash (–A) ................................................................................... 640 Incurred and paid interest. Notes Payable (–L) .......................................................................... 8,000 Cash (–A) ................................................................................... 8,000 Repaid notes payable.

b. Stated interest rate = 0%

Face value .................................................................................. $ 8,000.00

Present value (i = 8%, n = 2)

Present value of face value

$8,000 .8573 (from Table 4 in Appendix A) ..................... 6,858.40

Discount on notes payable ........................................................ $ 1,141.60

Cash (+A) ......................................................................................... 6,858.40 Discount on Notes Payable (–L) ...................................................... 1,141.60 Notes Payable (+L) .................................................................... 8,000.00 Issued notes payable. Interest Expense (E, –SE) ............................................................... 548.67 Discount on Notes Payable (+L) ............................................... 548.67 Incurred interest. Interest Expense (E, –SE) ............................................................... 592.93 Discount on Notes Payable (+L) ............................................... 592.93 Incurred interest.

Notes Payable (–L) .......................................................................... 8,000.00 Cash (–A) ................................................................................... 8,000.00 Repaid notes payable.

c. Stated interest rate = 6% Face value ....................................................................................... $8,000.00 Present value (i = 8%, n = 2) Present value of face value

$8,000 .8573 (from Table 4 in Appendix A) .......................... $6,858.40 Present value of interest payments

($8,000 6%) 1.7833 (from Table 5 in Appendix A) ............ 855.98 Total present value .......................................................................... 7,714.38 Discount on notes payable .............................................................. $ 285.62

Cash (+A) ......................................................................................... 7,714.38 Discount on Notes Payable (–L) ...................................................... 285.62 Notes Payable (+L) .................................................................... 8,000.00 Issued notes payable.

Interest Expense (E, –SE) ............................................................... 617.15a

Discount on Notes Payable (+L) ............................................... 137.15b

Cash (–A) ................................................................................... 480.00c Incurred and paid interest. a $617.15 = Book Value Effective Interest Rate = 7,714.38 8%

b $137.15 = Interest Expense – Interest Payment

c $480.00 = Face Value Stated Interest Rate = $8,000 6%

Interest expense (E, –SE)................................................................ 628.47a

Discount on Notes Payable (+L) ............................................... 148.47b Cash (–A) ................................................................................... 480.00 Incurred and paid interest.

a $628.47 = Book Value Effective Interest Rate = (7,714.38 + 137.15) 8%

b $148.47 = $8,000.00 – [$7,714.38 + $137.15 (from prior entry)]

Notes Payable (–L) .......................................................................... 8,000 Cash (–A) ................................................................................... 8,000 Repaid notes payable.

E11–7

a. Present value = Present value of face value + Present value of periodic interest payments

(1) Discount rate = 8% Present value of face value (i = 8%, n = 2)

($2,500 0.85734 from Table 4 in Appendix A) $ 2,143.35 Present value of periodic interest payments (i = 8%, n = 2)

($200 1.78326 from Table 5 in Appendix A) 356.65 Total present value $ 2,500.00







b. The effective interest rate is the interest rate that equates the undiscounted future cash flows with the present value of the future cash flows. In this case, the undiscounted future cash flows are (1) the $2,500 face value due in two years and (2) the interest payments of $200 due at the end of each year for two years, while the present value of the note is the proceeds of $2,413. From part (a), a discount rate of 10% equates the future cash flows and the proceeds. Therefore, the effective interest rate is 10%.

c. If Wilmes Floral Supplies originally borrowed $2,500, the $2,500 would be the present value of

the future cash flows. From part (a), a discount rate of 8% equates the future cash flows with $2,500. The effective interest rate would, therefore, be 8%. Anytime the proceeds equal the face value, the effective interest rate equals the stated interest rate.

E11–8

a. The building should be capitalized at the cash value of the transaction. In this particular case, the cash value of the transaction would be assumed to equal the building's appraised value. Therefore, the building should be recorded at $550,125.

b. The total present value of a note equals the sum of the present value of the note's face value and the present value of the periodic interest payments specified in the note. Since the note signed by Morrow Enterprises is non-interest-bearing, there are no periodic interest payments, and the present value of the note would equal just the present value of the note's face value.

(1) Discount Rate = 6%

Present Value = ($693,000 Present Value Factor for i = 6% and n = 3)

= $693,000 0.83962 from Table 4 in Appendix A)

= $581,856.66


Present Value = ($693,000 Present value factor for i = 8% and n = 3)


= $550,124.19


Present Value = ($693,000 Present value factor for i = 10% and n = 3)


= $520,657.83

c. The effective interest rate is the rate that equates the undiscounted future cash flows with the present value of the future cash flows. In this case, the undiscounted future cash flow is the $693,000 face value due in three years, and the present value of the note is the value of the building, or $550,125. From part (b), a discount rate of 8% equates the future cash flows and the proceeds. Therefore, the effective interest rate is 8%.

d. Since the note is non-interest-bearing, the only cash flow is the face value of $693,000. Dividing

the present value of $550,125 by the face value of $693,000 yields a present value factor of .79383. Looking across the n = 3 row of the present value of $1 table (i.e., Table 4) in Appendix A reveals that the annual effective interest rate on this note is 8%.

E11–9

a. Interest Expense = Effective Rate Book Value of Debt at Beginning of the Period

$16,400 = Effective Rate ($200,000 – $14,400) Effective Interest Rate = 8.8% (rounded)

b. Interest Expense (E, –SE) ............................................................... 16,400 Discount on Notes Payable (+L) ............................................... 2,400* Cash (–A) ................................................................................... 14,000 Incurred and paid interest.

* $2,400 = Change in the balance of Discount on Notes Payable

E11–10

a. The ten-year notes call for annual interest of $25.025 million (stated rate of 6.5% X face value of $385 million) and the repayment of $385 million in principal. The proceeds of the notes were $380 million. If the present value of the contract is $380 million and the future values are represented in the interest (ordinary annuity) and the principal (single sum), then the effective interest rate is the rate that discounts the future values to the present value of $380 million. The effective interest rate is approximately 6.7%. (The general present value formula of 1/[(1 + r) to the nth] was used in this calculation.)

b. The interest expense for 2002 will be the effective rate of 6.7% multiplied by the proceeds of $380 million, or $25.46 million. This amount is made up of $25.025 million of cash paid plus $.435 million of non-cash interest from the amortization of the bond discount.

c. The market paid less than $385 million for these bonds because the market demands 6.7% interest for their investment dollars for the risk posed by the company at the time of issuance. The notes only pay a cash interest rate of 6.5% and so the only way that investors can make their desired return is to pay less for the notes. This allows the investors to make the market rate of 6.7%.

E11–11

a. Bond A Face value ................................................................................. $ 100,000 Present value (i = 3%, n = 20) PV of face value

($100,000 0.55368 from Table 4 in Appendix A) ............... $ 55,368 PV of periodic interest payments ($3,000 x 14.87747 from Table 5 in Appendix A) ................. 44,632 Total present value (i.e., proceeds) ........................................... 100,000 Discount/premium ...................................................................... $ 0

Bond B Face value ................................................................................. $ 400,000 Present value (i = 3%, n = 20) PV of face value

($400,000 0.55368 from Table 4 in Appendix A) ............... $ 221,472 PV of periodic interest payments

($16,000 14.87747 from Table 5 in Appendix A) ............... 238,040 Total present value (i.e., proceeds) ........................................... 459,512 Premium ..................................................................................... $ 59,512 Bond C Face value ................................................................................. $ 600,000 Present value (i = 4%, n = 10) PV of face value

($600,000 0.67556 from Table 4 in Appendix A) ............... $ 405,336 PV of periodic interest payments

($18,000 8.11090 from Table 5 in Appendix A) ................. 145,996 Total present value (i.e., proceeds) ........................................... 551,332 Discount ..................................................................................... $ 48,668

b. Immediately before a bond matures, its carrying value on the balance sheet must equal its face value. Thus, discounts and premiums must be amortized over time so that the carrying value approaches the bond's face value over time. For bonds that are issued at their face value, such as Bond A, the bond is already stated at its face value and there is no discount or premium to amortize. Consequently, the carrying value of the bond will remain equal to its face value over the life of the bond. Thus, the carrying value of Bond A will remain constant over its life.

For bonds issued at a discount, such as Bond C, the carrying value on the date the bond is issued is less than its face value. Consequently, over the life of the bond, its carrying value must increase as the discount is amortized. Remember that a discount on a bond is deducted from the bond's face value to determine the carrying value. Thus, any reduction in the discount balance, such as when the discount is being amortized, will decrease the amount being deducted from the face value which thereby increases the carrying value of the bond. The carrying value of Bond C will, therefore, increase over its life.

Alternatively, the carrying value of Bond B will decrease over its life. For bonds issued at a premium, such as Bond B, the carrying value on the date the bond is issued is greater than its face value. Consequently, over the life of the bond, its carrying value must decrease as the premium is amortized. Remember that a premium on a bond is added to the bond's face value to determine the carrying value. Thus, any reduction in the premium balance, such as when the premium is being amortized, will decrease the amount being added to the face value which thereby decreases the carrying value of the bond. Thus, the carrying value of Bond B will decrease over its life.

c. Interest expense is computed as the bond's book value at the beginning of the accounting period

times the effective interest rate per period. Since accountants use the effective interest rate on the date a bond is issued to calculate interest expense, the effective interest rate is constant over the bond's life. This implies that the only factor that could affect whether the interest expense recognized each period increases, decreases, or remains constant over the life of the bond is the book value.

As discussed in part (b), the book value of Bond A will remain constant over the life of the bond issue. Consequently, the interest expense recognized in each accounting period will remain constant over the life of Bond A. Alternatively, the interest expense recognized for Bonds B and C will vary across periods. Since the book value of Bond B will decrease over the life of the bond issue [see part (b)], interest expense associated with Bond B will also decrease from one period to the next. The interest expense associated with Bond C will increase from one period to the next because the book value of Bond C will increase each period [see part (b)].

E11–12

a. 1/1/11 Cash (+A) ................................................................... 30,000 Bonds Payable (+L) ............................................. 30,000 Issued bonds for cash.

b. 6/30/11 Interest Expense (E, –SE) ......................................... 1,500a

Cash (–A) ............................................................. 1,500b Incurred and paid interest. a $1,500 = Book Value Effective Interest Rate per Period = $30,000 5%

b $1,500 = Face Value Stated Interest Rate per Period = $30,000 5%

12/31/11 Interest Expense (E, –SE) ......................................... 1,500 Cash (–A) ............................................................. 1,500 Incurred and paid interest.

c. Balance Sheet Value = Face Value – Associated Discount + Associated Premium

= $30,000 – $0 + $0

= $30,000

d. Present value (i = 5%, n = 18) PV of face value

($30,000 .4155) ........................................................................ $12,465 PV of interest payments

($1,500 11.6896) ...................................................................... 17,534 Total present value .......................................................................... $30,000

e. Balance Sheet Value as of 12/31/12

= Face Value – Associated Discount + Associated Premium

= $30,000 – $0 + $0

= $30,000

Present value as of 12/31/12 (i = 5%, n = 16) PV of face value

($30,000 .4581) ........................................................................ $13,743 PV of interest payments

($1,500 10.8378) ...................................................................... 16,257 Total present value .......................................................................... $30,000

Notice that the balance sheet value of $30,000 is identical to the present value just calculated. Amortizing premiums and discounts using the effective interest rate results in bonds being carried on the balance sheet at an amount equal to the present value of the future cash flows of the bonds, using the effective interest rate on the date the bonds were issued as the discount rate.

E11–13

a. Face value .............................................................................. $ 500,000 Present value (i = 4%, n = 10) PV of face value

($500,000 0.6756 from Table 4 in Appendix A) .............. $ 337,800 PV of interest payments

($15,000 8.1109 from Table 5 in Appendix A) ................ 121,664 Total present value ................................................................. 459,464 Discount .................................................................................. $ 40,536

Cash (+A) ....................................................................................... 459,464 Discount on Bonds Payable (–L) ................................................... 40,536 Bonds Payable (+L) ................................................................. 500,000 Issued bonds.

b. Interest Expense (E, –SE) ............................................................. 18,378.56a

Discount on Bonds Payable (+L) ............................................. 3,378.56c

Interest Payable (+L) ............................................................... 15,000.00b Accrued interest payable.

a $18,378.56 = Book Value Effective Rate per Period = $459,464 4%

b $15,000.00 = Face Value Stated Rate per Period = $500,000 3%

c $3,378.56 = $18,378.56 – $15,000.00

c. Balance sheet value as of 12/31/12 = Face value – Discount as of 12/31/12 = $500,000.00 – ($40,536.00 – $3,378.56) = $462,842.56 d. Present value (i = 4%, n = 9)

PV of face value

($500,000 0.7026 from Table 4 in Appendix A) ..................... $ 351,300.00 PV of interest payments

($15,000 7.4353 from Table 5 in Appendix A) ....................... 111,530.00 Total present value ........................................................................ $ 462,830.00

Notice that the $462,842.56 from part [c] is essentially identical to the $462,830.00 just calculated. Amortizing discounts and premiums using the effective interest rate results in bonds being carried on the balance sheet at an amount equal to the present value of the bonds, using the effective interest rate on the date the bonds were issued as the discount rate.

E11–14

a. Face value .............................................................................. $ 100,000 Present value (i = 3%, n = 20) PV of face value

($100,000 0.55368 from Table 4 in Appendix A) ............ $ 55,368 PV of interest payments

($4,000 14.87747 from Table 5 in Appendix A) .............. 59,510 Total present value ................................................................. 114,878 Premium .................................................................................. $ 14,878

Cash (+A) ....................................................................................... 114,878 Premium on Bonds Payable (+L) ............................................ 14,878 Bonds Payable (+L) ................................................................. 100,000 Issued bonds.

b. Interest Expense (E, –SE) ............................................................. 3,446.34a

Premium on Bonds Payable (-L) ................................................... 553.66c

Interest Payable (+L) ............................................................... 4,000.00b Accrued interest payable.

a $3,446.34 = Book Value Effective Rate per Period = $114,878 3%

b $4,000.00 = Face Value Stated Rate per Period = $100,000 4%

c $553.66 = $4,000.00 – $3,446.34

c. Balance sheet value as of 12/31/12 = Face value + Premium as of 12/31/12 = $100,000.00 + ($14,878.00 – $553.66) = $114,324.34 d. Present value (i = 3%, n = 19)

PV of face value

($100,000 0.57029 from Table 4 in Appendix A) ................... $ 57,029.00 PV of interest payments

($4,000 14.3238 from Table 5 in Appendix A) ....................... 57,295.20 Total present value ........................................................................ $ 114,324.20

Notice that the $114,324.34 from part [c] is essentially identical to the $114,324.20 just calculated. Amortizing discounts and premiums using the effective interest rate results in bonds being carried on the balance sheet at an amount equal to the present value of the bonds, using the effective interest rate on the date the bonds were issued as the discount rate.

E11–21

a. The effective interest rate can be calculated in two ways. The first way is by solving for i in the following equation where n=2 since there are two periods until maturity (12/31/12, the balance sheet date and maturity at 12/31/14).

$193,059 = [($200,000 (1 + i )-2] + {$10,000 [(1 – [(1 + i)-2 + i ]}

The second way is by trial and error. Simply plug an interest rate into the equation above until the right-hand side of the equation equals the left hand side. Since the bond is issued at a discount, we start with the knowledge that the effective rate is greater than the stated rate of 5%. The annual effective interest rate for the bonds is 6.92%.

b. To determine the effective rate an investor would be earning if the bonds were purchased on

12/31/12 at the market value of $186,479, perform the same procedure using the equation.

$186,479 = [($100,000 (1 + i )-2] + {$5,000 [(1 – [(1 + i)-2 + i ]}

The annual effective interest rate for the bonds is 8.83%. c. The book value of the bonds on Cohort Enterprises’ books at December 31, 2012 is $193,059.

The market value of the bonds as of December 31, 2012 is $186,479. The difference represents a gain of $6,580. It is a gain because if Cohort Enterprises were to repurchase these bonds on the market in order to retire them, it would have to pay $6,580 less than the book value.

Net income $38,500

Unrealized holding gain on Bonds Payable 6,580

Adjusted net income $45,080

The gain is not an increase in the wealth of the company if it intends to keep the bonds outstanding until maturity. However, if Cohort intends to retire this debt, the gain represents an increase in wealth because Cohort will acquire additional net assets of $6,580.

d.

Bonds payable ................................................................................ 200,000 Discount on Bonds Payable ...................................................... 6,941 Cash........................................................................................... 186,479 Extraordinary Realized Gain on Retirement of Debt ................. 6,580

Once the repurchase has occurred, the loss has been realized because a reduction in net assets has occurred. Before this occurs, however, the loss is unrealized and may be misleading if the company intends to keep the bonds until maturity.

E11–22

a. Lease Expense (E, –SE) ................................................................. 10,000 Cash (–A) ................................................................................... 10,000 Incurred and paid lease expense for 2011. Lease Expense (E, –SE) ................................................................. 10,000 Cash (–A) ................................................................................... 10,000 Incurred and paid lease expense for 2012. Lease Expense (E, –SE) ................................................................. 10,000 Cash (–A) ................................................................................... 10,000 Incurred and paid lease expense for 2013. Lease Expense (E, –SE) ................................................................. 10,000 Cash (–A) ................................................................................... 10,000 Incurred and paid lease expense for 2014. Lease Expense (E, –SE) ................................................................. 10,000 Cash (–A) ................................................................................... 10,000 Incurred and paid lease expense for 2015. b. The effective interest rate on the lease is 8%. The following entries would be recorded on Q-

Mart’s books. Facility (A) ........................................................................................ 39,927 Lease Liability (L) ...................................................................... 39,927

Record the capitalized lease. ($10,000*3.9927) Depreciation Expense (E, –SE) ....................................................... 7,985.40 Accumulated Depreciation (–A) ................................................. 7,985.40 Record depreciation of capitalized asset for 2011. ($39,927/5) Lease Liability (-L) ........................................................................... 6,805.84 Interest Expense (E, -SE) ................................................................ 3,194.16 Cash (-A) ................................................................................... 10,000 Made lease payment for 2011. Depreciation Expense (E, –SE) ....................................................... 7,985.40 Accumulated Depreciation (–A) ................................................. 7,985.40 Record depreciation of capitalized asset for 2012. Lease Liability (-L) ........................................................................... 7,350.32 Interest Expense (E, -SE) ................................................................ 2,649.68 Cash (-A) ................................................................................... 10,000 Made lease payment for 2012. Depreciation Expense (E, –SE) ....................................................... 7,985.40 Accumulated Depreciation (–A) ................................................. 7,985.40 Record depreciation of capitalized asset for 2013. Lease Liability (-L) ........................................................................... 7,938.32

Interest Expense (E, -SE) .......................................................... 2,061.68 Cash (-A) ................................................................................... 10,000 Made lease payment for 2013. Depreciation Expense (E, –SE) ....................................................... 7,985.40 Accumulated Depreciation (–A) ................................................. 7,985.40 Record depreciation of capitalized asset for 2014. Lease Liability (-L) ........................................................................... 8,573.36 Interest Expense (E, -SE) ................................................................ 1,426.64 Cash (-A) ................................................................................... 10,000 Made lease payment for 2014. Depreciation Expense (E, –SE) ....................................................... 7,985.40 Accumulated Depreciation (–A) ................................................. 7,985.40 Record depreciation of capitalized asset for 2015. Lease Liability (-L) ........................................................................... 9,260.00 Interest Expense (E, -SE) ................................................................ 740.00 Cash (-A) ................................................................................... 10,000 Made lease payment for 2015. c. Classifying the lease as an operating lease would give rise to both higher net income and a

lower debt/equity ratio. By classifying the lease as an operating lease, net income would be reduced during 2011 by $10,000 [from part (a)] for rent expense. Alternatively, classifying the lease as a capital lease would reduce net income by a total of $11,179.56 [from part (b)] for the interest expense associated with the lease and for the depreciation associated with the capitalized asset.

Future obligations under operating leases are not disclosed in a company's financial statements as a liability. Consequently, an operating lease would not affect a company's total liabilities. On the other hand, the present values of future lease obligations are reported as liabilities under capital leases, which means that a capital lease results in increased liabilities compared to an operating lease. In addition, the differential effect of capital and operating leases on net income will affect total stockholders' equity through Retained Earnings. Specifically, the balance in Retained Earnings, and thus total stockholders' equity, will be higher by classifying the lease as an operating lease as opposed to classifying it as a capital lease. Therefore, Q-Mart’s total liabilities would be lower and its stockholders' equity higher if the lease were classified as an operating lease rather than as a capital lease. This means that classifying the lease as an operating lease would yield a lower debt/equity ratio. At the end of the useful life both will be equal.

E11–23

a. Annual Rental Expense = Rental Expense per Car Number of Cars

= $10,000 100 cars = $1,000,000

b. Present Value of Lease Payments = $10,000 per Car 100 Cars x Present Value of an Ordinary Annuity Factor for i = 10%, n = 5

= $1,000,000 3.7908 from Table 5 in Appendix A = $3,790,800

Automobiles (+A) .......................................................................... 3,790,800 Lease Liability (+L) ................................................................. 3,790,800 Leased automobiles.

c. Interest Expense = Lease Obligation 10%

= $3,790,800 10% = $379,080

Depreciation Expense = Cost of Automobiles ÷ 5 Years = $3,790,800 ÷ 5 = $758,160 Total Rental Expense = Interest Expense + Depreciation Expense = $379,080 + $758,160 = $1,137,240

d. Classifying the lease as an operating lease would give rise to both higher net income and a lower debt/equity ratio. By classifying the lease as an operating lease, net income would be reduced during 2011 by $1,000,000 [from part (a)] for rent expense. Alternatively, classifying the lease as a capital lease would reduce net income by a total of $1,137,240 [from part (c)] for the interest expense associated with the lease and for the depreciation associated with the capitalized asset.

Future obligations under operating leases are not disclosed in a company's financial statements as a liability. Consequently, an operating lease would not affect a company's total liabilities. On the other hand, the present values of future lease obligations are reported as liabilities under capital leases, which means that a capital lease results in increased liabilities compared to an operating lease. In addition, the differential effect of capital and operating leases on net income will affect total stockholders' equity through Retained Earnings. Specifically, the balance in Retained Earnings, and thus total stockholders' equity, will be higher by classifying the lease as an operating lease as opposed to classifying it as a capital lease. Therefore, Tradeall's total liabilities would be lower and its stockholders' equity higher if the lease were classified as an operating lease rather than as a capital lease. This means that classifying the lease as an operating lease would yield a lower debt/equity ratio.

e. Off-balance sheet financing refers to financing agreements that require future payments, yet are structured so that the financing arrangement does not meet any of the criteria for the financing arrangement to be reported as a liability. The substance of an operating lease is considered to be a rental agreement. This implies that a company does not incur an obligation under the lease until it actually uses the item being leased. Thus, the future obligations under the lease should not be reported as a liability. Alternatively, the substance of a capital lease is considered to be a purchase agreement. This implies that the company has, in substance, acquired an asset and that the lease is simply a note payable for the acquisition of that asset. Thus, the present value of the future cash outflows specified in the lease agreement should be reported as a liability. The difference between operating and capital leases provides a way for companies to engage in off-balance-sheet financing. That is, by structuring a lease agreement as an operating lease, the lessee can engage in off-balance sheet financing.

PROBLEMS

P11–2

a. The bonds will be issued at a discount. The bond market has determined that purchasers of Hartl Enterprises' bonds should earn an annual return on their investment of 10%. However, Hartl Enterprises is offering interest equal to only 8%. Since the stated interest rate cannot be changed, the only way that the investors can earn their 10% return is to invest a smaller amount in Hartl Enterprises. They will still receive the same future cash flows. Consequently, the bonds will be issued at a price that allows the investors to earn a return of exactly 10% on their investment.

b. Face value .................................................................................... $ 10,000 Present value (i = 5%, n = 20) PV of maturity receipt

($10,000 .3769 from Table 4 in Appendix A) ................... $ 3,769 PV of interest receipts

($400 12.4622 from Table 5 in Appendix A) .................... 4,985 Total present value ....................................................................... 8,754 Discount ........................................................................................ $ 1,246 Cash (+A) ......................................................................................... 8,754 Discount on Bonds Payable (–L) ..................................................... 1,246 Bonds Payable (+L) ................................................................... 10,000 Issued bonds.

c. Interest Expense (E, –SE) ............................................................... 218.85a

Discount on Bonds Payable (+L) ............................................... 18.85b

Interest Payable (+L) ................................................................. 200.00c Accrued interest payable.

a $218.85 = Book value Effective rate per period Portion of period outstanding

= $8,754 5% 3/6 b $18.85 = Interest expense – Interest payable c $200.00 = Face value Stated rate per period Portion of period outstanding

= $10,000 4% 3/6 d. Interest Expense (E, –SE) ............................................................... 218.85 Interest Payable (–L) ....................................................................... 200.00 Discount on Bonds Payable (+L) ............................................... 18.85 Cash (–A) ................................................................................... 400.00 Made interest payment.

P11–3

a. L-T Debt/Equity Ratio = Total Long-Term Liabilities ÷ Total Stockholders' Equity = $40,000 ÷ $100,000 = 0.4

b. Proceeds = Present Value of Future Cash Flows Discounted at 11% for 5 Periods

= $40,000 .59345 (from Table 4 in Appendix A) = $23,738 If Manheim Corporation borrows this $40,000, its long-term debt/equity ratio would be .637

[($40,000 + $23,738) ÷ $100,000]. c. Proceeds = Present Value of Future Cash Flows Discounted at 4% for 40 Periods = Present Value of the Face Value + Present Value of Interest Payments

= ($40,000 .20829 from Table 4 in Appendix A) + [($40,000 5%)

19.79277 (from Table 5 in Appendix A)] = $8,332 + $39,586 = $47,918 If Manheim Corporation issues these bonds, its long-term debt/equity ratio would be .879

[($40,000 + $47,918) ÷ $100,000].

P11–4

a. Note A Face value ................................................................................. $ 20,000 Present value (i = 10%, n = 5) PV of face value

($20,000 .6209 from Table 4 in Appendix A) ................ $ 12,418 PV of interest receipts

($0 3.7908 from Table 5 in Appendix A) ....................... 0 Total present value (i.e., proceeds) ........................................... 12,418 Discount ..................................................................................... $ 7,582

Note B

Face value ................................................................................. $ 35,000 Present value (i = 10%, n = 8) PV of face value


($2,800 5.3349 from Table 5 in Appendix A) ................ 14,938 Total present value (i.e., proceeds) ........................................... 31,266 Discount ..................................................................................... $ 3,734 Note C Face value ................................................................................. $ 50,000 Present value (i = 4%, n = 20) PV of face value


($2,000 13.5903 from Table 5 in Appendix A) .............. 27,181 Total present value (i.e., proceeds) ........................................... 50,000 Discount/premium ...................................................................... $ 0

b. Note A Cash (+A) ......................................................................................... 12,418.00 Discount on Notes Payable (–L) ...................................................... 7,582.00 Notes Payable (+L) .................................................................... 20,000.00 Issued notes payable for cash.

Note B Cash (+A) ......................................................................................... 31,266.00 Discount on Notes Payable (–L) ...................................................... 3,734.00 Notes Payable (+L) .................................................................... 35,000.00 Issued notes payable for cash. Note C Cash (+A) ......................................................................................... 50,000.00 Notes Payable (+L) .................................................................... 50,000.00 Issued notes payable for cash.

c. Interest Expense (E, –SE) ............................................................... 2,000.00 Cash (–A) ................................................................................... 2,000.00 Incurred and paid interest. d. Note B

Interest Expense (E, –SE) ............................................................... 3,126.60a

Discount on Notes Payable (+L) ............................................... 326.60b

Cash (–A) ................................................................................... 2,800.00c Incurred and paid interest.

a $3,126.60 = Book Value Effective Rate per Period = ($35,000 – $3,734) 10% b $326.60 = Interest Expense – Interest Payment c $2,800.00 = Face Value Stated Rate per Period = $35,000 8%

Note C Interest Expense (E, –SE) ............................................................... 2,000.00 Cash (–A) ................................................................................... 2,000.00 Incurred and paid interest.

e. Interest Expense (E, –SE) ............................................................... 1,241.80* Discount on Notes Payable (+L) ............................................... 1,241.80 Amortized discount on notes payable. _________________

* $1,241.80 = Book Value Effective Rate per Period = ($20,000 – $7,582) 10%

P11–6

a. The Amount of Interest Payments = Face Value of Debt Stated Interest Rate

= $800,000 10% = $80,000 b. When the note payable was issued, the stated interest rate did not equal the effective interest

rate; the effective interest rate exceeded the stated interest rate. Consequently, the proceeds from the note were less than face value, so that the entire loan to Rix Driving Range and Health Club would actually earn the effective interest rate on its money. The excess of the face value over the proceeds gave rise to the Discount on Notes Payable, and from Rix's viewpoint, this account effectively represents prepaid interest. Over the life of the note, this discount will be amortized to Interest Expense. Consequently, the difference between the balance in Interest Expense and the cash paid out for interest payments represents the amortization of the Discount on Notes Payable.

c. Interest Expense = Book Value at Beginning of the Period Effective Interest Rate

$95,000 = ($800,000 – $70,000) Effective interest rate Rate = 13% (rounded)

d. Interest Expense (E, –SE) ............................................................... 95,000 Discount on Notes Payable (+L) ............................................... 15,000

Cash (–A) ................................................................................... 80,000 Incurred and paid interest.

P11–7

a. Face value ................................................................................ $ 20,000.00 Present value (i = 4%, n = 12) PV of cash payment at maturity

($20,000 0.6246 from Table 4 in Appendix A) ............. $ 12,492.00 PV of cash interest payments

($600 9.3851 from Table 5 in Appendix A) .................. 5,631.06 Total present value ................................................................... 18,123.06 Discount on bonds .................................................................... $ 1,876.94

b. Face value ................................................................................ $ 20,000.00 Present value (i = 4%, n = 11) PV of cash payment at maturity

($20,000 0.6496 from Table 4 in Appendix A) ............. $ 12,992.00 PV of cash interest payments

($600 8.7605 from Table 5 in Appendix A) .................. 5,256.30 Total present value ................................................................... 18,248.30 Discount on bonds .................................................................... $ 1,751.70

The present value of the cash flows on these bonds as of December 31, 2012, using the effective interest rate on the date the bonds were originally issued, represents the book value of the bonds as of December 31, 2012.

c. The difference of $125.24 in present values from June 30, 2012 and December 31, 2012 represents

the change in book value of these bonds for this six-month period. The change in book value would

be captured by the amortization of the Discount on Bonds Payable account.

d. Interest Expense (E, –SE) ............................................................... 724.92a

Discount on Bonds Payable (+L) ............................................... 124.92b

Cash (–A) ................................................................................... 600.00c Incurred and paid interest.

a $724.92 = Book Value Effective Rate per Period = $18,123.06 4% b $124.92 = Interest Expense – Interest Payment c $600.00 = Face Value Stated Rate per Period = $20,000 3% The amount of discount on bonds payable is essentially the same as the amount in part (c); the difference of 32¢ is due to rounding. Under the effective-interest method, bonds are carried on the balance sheet at their present value (based upon the effective rate at the initial date of issue) at that particular point in time. Hence, it makes no difference if one computes the present value of the cash outflows associated with bonds or applies the effective-interest method; both methods will yield essentially identical financial statements.

P11–8

a. To compute the amount of money that Ross Running Shoes must invest on June 30, 2012, the future cash flows must be discounted at the investment rate of 8%. Since the investment rate is an annual rate, and interest is paid semiannually, the rate must be adjusted to a six-month rate of 4%. Therefore, i = 4% and n = 6.

Present Value = Present Value of Face Value + Present Value of Interest Payments

= ($10,000 .79031 from Table 4 in Appendix A) + [($10,000

5%) 5.24214 from Table 5 in Appendix A] = $7,903.10 + $2,621.07 = $10,524.17

b. Interest Expense (E, –SE) ............................................................... 420.97a

Premium on Notes Payable (–L) ..................................................... 79.03b


a $420.97 = Book Value Effective Rate per Period = ($10,000 + $524.17) 4% b $79.03 = Interest Expense – Interest Payment c $500.00 = Face Value Stated Rate per Period = $10,000 5%

c. Interest Expense (E, –SE) ............................................................... 412.64a

Premium on Notes Payable (–L) ..................................................... 87.36b


a $412.64 = Interest Payment – Premium Amortization b $87.36 = Total Premium ÷ Number of 6-Month Periods = $524.17 ÷ 6 periods c $500.00 = Face Value Stated Rate per Period = $10,000 5%

P11–8 Concluded

d. Under the effective-interest method, the company will recognize interest expense during 2012 of $420.97 [from part (b)]. Under the straight-line method, the company will recognize interest expense during 2012 of $412.64 [from part (c)]. Thus, the straight-line method results in lower expenses and higher net income in the early periods of a note issued at a premium.

e. Over the life of a note or bond, both the effective-interest and straight-line methods will amortize

the entire discount or premium balance. Consequently, over the life of a note or bond, both methods will amortize exactly the same amount of discount or premium. As noted in part (d), for notes issued at a premium, the straight-line method will recognize lower interest expense than the effective-interest method in the early years of the note's life. The lower interest expense recognized under the straight-line method will eventually have to be offset if both methods are to recognize the same amount of interest expense over the life of the note. Consequently, the straight-line method will have to recognize “relatively” higher interest expense and, hence, lower net income in the later years of a note issued at a premium.

P11–9

a. Note A

1/1/12 12/31/12

Present value (i = 6%, n = 3) Present value (i = 6%, n = 2)

PV of face value PV of face value

($1,000 .8396) $ 839.60 ($1,000 .8900) $ 890.00

PV of interest payment PV of interest payment

($100 2.6730) 267.30 ($100 1.8334) 183.34

Total present value $ 1,106.90 Total present value $ 1,073.34

12/31/13


PV of face value

($1,000 .9434) $ 943.40

PV of interest payment

($100 .9434) 94.34

Total present value $ 1,037.74

Note B

1/1/12 12/31/12



($1,000 .75132) $ 751.32 ($1,000 .82645) $ 826.45


($100 2.48685) 248.69 ($100 1.73554) 173.55

Total present value $ 1,000.00 Total present value $ 1,000.00

12/31/13


PV of face value

($1,000 .90909) $ 909.10


($100 .90909) 90.91

Total present value $ 1,000.00

Note C

1/1/12 12/31/12



($1,000 .75132) $ 751.32 ($1,000 .82645) $ 826.45


($60 2.48685) 149.21 ($60 1.73554) 104.13

Total present value $ 900.53 Total present value $ 930.58

12/31/13


PV of face value

($1,000 .90909) $ 909.09


($60 .90909) 54.55

Total present value $ 963.64

b.

Interest Payment Disc./Prem. Face Disc./Prem. Book

Date Expense Amount Amortization Value Balance Value

Note A

1/1/12 $1,000.0

0

$106.90 $1,106.90

12/31/12 $66.42 $100.00 $33.58 1,000.00 73.32 1,073.32

12/31/13 64.40 100.00 35.60 1,000.00 37.71 1,037.73

12/31/14 62.26 100.00 37.74 1,000.00 ($0.00) 1,000.00

Note B

1/1/12 $1,000.0

0

$0.00 $1,000.00

12/31/12 $100.00 $100.00 $0.00 1,000.00 0.00 1,000.00

12/31/13 100.00 100.00 0.00 1,000.00 0.00 1,000.00

12/31/14 100.00 100.00 0.00 1,000.00 0.00 1,000.00

Note C

1/1/12 $1,000.0

0

$99.48 $900.52

12/31/12 $90.05 $60.00 $30.05 1,000.00 69.43 930.57

12/31/13 93.06 60.00 33.06 1,000.00 36.37 963.63

12/31/14 96.36 60.00 36.37 1,000.00 ($0.00) 1,000.00

c.

Interest Payment Disc./Prem. Face Disc./Prem. Book

Date Expense Amount Amortization Value Balance Value

Note A

1/1/12 $1,000.00 $106.90 $1,106.90

12/31/12 $64.37 $100.00 $35.63 1,000.00 71.27 1,071.27

12/31/13 64.37 100.00 35.63 1,000.00 35.63 1,035.63

12/31/14 64.37 100.00 35.63 1,000.00 0.00 1,000.00

Note B

1/1/12 $1,000.00 $0.00 $1,000.00

12/31/12 $100.00 $100.00 $0.00 1,000.00 0.00 1,000.00

12/31/13 100.00 100.00 0.00 1,000.00 0.00 1,000.00

12/31/14 100.00 100.00 0.00 1,000.00 0.00 1,000.00

Note C

1/1/12 $1,000.00 $99.48 $900.52

12/31/12 $26.84 $60.00 $33.16 1,000.00 66.32 933.68

12/31/13 26.84 60.00 33.16 1,000.00 33.16 966.84

12/31/14 26.84 60.00 33.16 1,000.00 ($0.00) 1,000.00

d. Compare parts (b) and (c) to part (a). The effective interest method maintains the net book value of the liability equal to the present value of the future cash flows of the liability throughout the liability's life. Alternatively, the straight-line method does not maintain this equality. Further, under the effective interest method, interest expense is always the same percentage of the outstanding debt throughout the life of the liability. This constant relationship arises because interest expense is computed as the book value times the effective interest rate, and since the effective interest rate is assumed to be constant, interest expense remains a constant percentage of the liability. The straight-line method does not result in this constant relationship between interest expense and the outstanding liability, as evidenced by the amounts reported under interest expense in part (c).

P11–10

a. Book Value of Debt = Face Value of $500,000 + Premium Balance of $12,600 = $512,600

Cash Paid to Retire Debt = Face Value 104%

= $500,000 104% = $520,000 Loss = Excess of Cash Paid Over Book Value = $512,600 – $520,000 = $7,400

b. Cash Paid to Retire Debt = Face Value 108%

= $500,000 108% = $540,000

Loss = Excess of Cash Paid Over Book Value = $540,000 – $512,600 = $27,400

c. Ginny and Bill Eateries is required to make an interest payment on June 30, 2012 under the

terms of the debt agreement. The entry to record this payment would be:

Interest Expense (E, –SE) ............................................................... 15,378a

Premium on Bonds Payable (–L) ..................................................... 4,622b

Cash (–A) ................................................................................... 20,000c Incurred and paid interest.

a $15,378 = Book Value Effective Rate per Period = $512,600 3%

b $4,622 = Interest Expense – Interest Payment

c $20,000 = Face Value Stated Rate per Period = $500,000 4% Book Value of Debt = Face Value + Premium Balance = $500,000 + ($12,600 – $4,622) = $507,978

Cash Paid to Retire Debt = Face Value 110%

= $500,000 110% = $550,000 Loss = Excess of Cash Paid Over Book Value = $550,000 – $507,978 = $42,022

P11–13

a. On the financial statements a capital lease is treated like the company had purchased the fixed assets. The asset and the related liability are recorded on the balance sheet and interest and depreciation are recorded on the income statement. An operating lease is treated like a recurring expense each month but nothing is recorded on the balance sheet. The amount of the lease payment is shown as an expense each month.

a. A company may want to treat leases as operating leases because there is no debt that is recorded on the balance sheet. This treatment impacts a number of financial ratios (debt-to-equity, for example) and so may be to the company’s advantage to treat it like an operating lease.

b. total liability ÷ total asset ratio if Wal-Mart treats these leases as:

currently recorded: $98 ÷ $163 = 60.1%

if all leases are capital leases: $106.1 (98 + 8.1) ÷ $171.1 (163 + 8.1) = 62.0%

$3.5 ÷ $5.5 = 63.6%, 63.6% of $12.8 billion = $8.1 billion

d. An analyst needs to be able to compare companies that use different methods for accounting for leases. If an analyst does not do this additional analysis there is a good chance that the analyst will be misled as to the relative performance of the companies. The more leases that the companies have on their books, the more this difference between operating leases and capital leases could affect the analysis of the companies. A review of “off-balance sheet financing” is always a prudent step in financial analysis.

P11–14

a. The initial balance sheet value of the equipment and the initial leasehold obligation both equal the present value of the lease payments. This amount can be determined in the following ways.

Present value of lease payments = FMV of equipment = $119,782

or

Present value of lease payments = Present value of lease payments

= $30,000 Present value of an ordinary annuity factor for i = 8% and n = 5

= $30,000 3.99271 (from Table 5 in Appendix A) = $119,781.30

Balance

Sheet

Value of Leasehold Interest Depr. Total

Date Equipmenta Obligationb Expensec Expensed Expense

1/1/11 $119,781.3

0

$119,781.3

0

12/31/1

1

95,825.04 99,363.80 $9,582.50 $23,956.26 $33,538.76

12/31/1

2

71,868.78 77,312.91 7,949.10 23,956.26 31,905.36

12/31/1

3

47,912.52 53,497.94 6,185.03 23,956.26 30,141.29

12/31/1

4

23,956.26 27,777.78 4,279.84 23,956.26 28,236.10

12/31/1

5

(0.00) (0.00) 2,222.22 23,956.26 26,178.48

Total $30,218.70 $119,781.3

0

$150,000.00e

a Balance Sheet Value of Equipment = Value of Equipment on 1/1/11 – Accum. deprec.

b Leasehold Obligation = Leasehold Obligation at Beginning of the Period – ($30,000

Lease Payment – Interest Expense for the Period)

c Interest Expense = Leasehold Obligation at Beginning of the Period 8%

d Depreciation Expense = $119,781.30 ÷ 5 years

e Total has penny discrepancy due to rounding to even cents throughout lease term.

b. Total Rent Expense = Annual Rent Payments Number of Years of the Lease

= $30,000 5 years = $150,000 c. If the lease is treated as a capital lease, total expenses would be $150,000 [from part (a)]. If the

lease is treated as an operating lease, total expenses would still be $150,000 [from part (b)]. Although total expenses would be the same under either approach, different expense accounts are affected under the two approaches. With a capital lease, the $150,000 is allocated between interest expense and depreciation expense, while with an operating lease, the entire $150,000 is allocated to rent expense.

P11–15

a. If the lease is treated as an operating lease, Thompkins Laundry would not have to report any liability associated with the lease. Therefore, its debt/equity ratio would be as follows.

Debt/Equity Ratio = Total Liabilities ÷ Stockholders' Equity = (Current Liabilities + Long-Term Liabilities) ÷ Stockholders' Equity = $30,000 ÷ $40,000 = 0.75 b. If the lease is treated as a capital lease, Thompkins Laundry would have to report a liability equal

to the present value of the future lease payments. Therefore, its debt/equity ratio would be affected.

Present value of lease payments = $5,000 Present value of an ordinary annuity factor for i = 12% and n = 5

= $5,000 3.60478 (from Table 5 in Appendix A) = $18,023.90 Debt/equity ratio = ($30,000 + $18,023.90) ÷ $40,000 = 1.20

c. Rent Interest Depreciation Total

Expense Expense ___Expense_ Expenses

Operating lease $5,000.00 $ 0.00 $ 0.00 $5,000.00

Capital lease 0.00 2,162.87 3,604.78 5,767.65

d. There are two primary reasons why Thompkins Laundry might want to arrange the terms of the lease agreement so that the lease would be classified as an operating lease rather than as a capital lease. First, lease obligations under an operating lease are not disclosed on the face of the balance sheet. Consequently, operating leases are essentially off-balance-sheet financing and will not affect any existing debt covenants that are based on reported liabilities. Second, in this case the capital lease classification results in higher expenses and, hence, lower net income in 2012 than the operating lease classification. Decreased net income would adversely affect any contracts, such as the manager's incentive contract, written on the basis of reported net income.

To avoid classifying this lease as a capital lease, Thompkins Laundry would have to arrange the terms so that the lease did not meet any of the criteria for capital leases. Consequently, the company would have to arrange the terms so that:

(1) the present value of the lease payments is less than 90% of the fair market value of the leased property;

(2) the term of the lease is less than 75% of the leased property's life; (3) the lessee does not have the right either during or at the expiration of the lease agreement

to purchase the property from the lessor at a nominal amount; or (4) ownership of the property is not transferred to the lessee from the lessor by the end of the

lease term.

ISSUES FOR DISCUSSION

ID11–1

a. A debenture is an unsecured bond. That is, there is no collateral supporting the bond. Thus, should the company not repay the bonds, investors do not have security in any of the company's assets that could be sold to repay the bonds. For this reason, unsecured bonds are riskier than secured bonds. Investors are compensated for this increased risk on debentures through a higher return (i.e., effective interest rate). Accordingly, these bonds would be priced lower than a secured bond in the same company.

b. There are three general reasons why a company would repurchase its outstanding debt. First,

the company may no longer need the money it borrowed. By repurchasing the debt, the company could avoid incurring interest. Second, due to a decrease in interest rates, the company may have repurchased its debt with the intent of issuing new debt at the lower prevailing interest rates. Finally, the company may repurchase some of its debt in an effort to improve its balance sheet. This would generally be in an effort to improve some financial ratios specified in debt covenants.

c. Repurchasing debt would decrease both a company's liabilities (due to the amount of debt

repurchased) and its assets (due to the cash paid out to repurchase the debt). For Sun Company, its stockholders' equity would also decrease because it paid out $957.50 for each bond when the book value of a bond was only $875. Thus, Sun Company would have a loss of $82.50 on each bond repurchased, which would decrease stockholders' equity through closing the loss into Retained Earnings.

d. Sun Company would not have recognized any loss if it had not repurchased its debt. Unless

there is evidence to the contrary, such as a company repurchasing its debt, accountants assume that when a company issues debt, the debt will remain outstanding until it matures. This implies that changes in the market value of the debt are irrelevant to the financial position of the company as reported in its financial statements.

ID11–2

a. The stated interest rate affects only the magnitude of periodic interest payments. What is important to investors is the rate of return on their investments. Thus, if an investor is not in need of periodic cash payments, a non-interest-bearing obligation that provides a competitive rate of return is an attractive investment option.

b. The rate that discounts $200 million due in eight years to a present value of $66.48 million is

14.75%. c. If bonds have a stated rate, the company has to have sufficient cash flow to make the periodic

interest payments. Thus, if a company does not expect to have sufficient cash flows to support periodic interest payments, it is to the company's advantage to issue bonds with a stated interest rate of zero.

d. To simplify the calculations, the effective interest rate of 14.75% [see part (b)] is rounded to 15%.

5% stated rate

Present value of $200 million paid in 8 years

$200 million .32690 (from Table 4 in Appendix A) ............................. $ 65,380,000

Present value of periodic interest payments

($200 million 5%) 4.48732 (from Table 5 in Appendix A) ................ 44,873,200

Issue price .................................................................................................. $ 110,253,200

18% stated rate

Present value of $200 million paid in 8 years

$200 million .32690 (from Table 4 in Appendix A) ............................. $ 65,380,000

Present value of periodic interest payments

($200 million 18%) 4.48732 (from Table 5 in Appendix A) .............. 161,543,520

Issue price .................................................................................................. $ 226,923,520

ID11–4

a. The current portion of Long Term Debt ($221 million) appeared in the Current Liabilities section of the balance sheet; the rest of the Long Term Debt, totaling $8,120 million, appeared in the long-term liabilities section of Johnson & Johnson’s balance sheet.

b. A zero coupon debenture is a debt instrument that has a stated rate of interest of 0%. The

debenture contract only requires the repayment of the face amount at maturity. However, because no company borrows at zero percent, the debentures are sold at a discount depending on the effective rate of interest. The zero coupon debenture that are due in 2020 carry an effective interest rate of 3.00, indicating that Johnson & Johnson did not receive the face value of the debentures at funding but will have to repay the face value at maturity (meaning that the company effectively is paying a 3% interest rate to borrow the money).

c. A bond contract with a stated rate of interest equal to the effective rate of interest will be sold at

par (no discount or premium). The 2033, 2023, 2017, 2038 and 2018 debentures carry effective rates equal to their stated rates, therefore selling at par.

d. The 6.95% notes due in 2029 were issued with an effective rate of interest of 7.14%, which is in

excess of the stated rate of 6.95%. Therefore, the notes were sold at a discount, meaning that the face amount is greater than the balance sheet amount of $293 million.

ID11–6

a. A large amount of debt forces a company's management to place greater emphasis on generating cash so that it has sufficient cash to make the required interest and principal payments. Thus, a company may alter its operating, investing, and financing decisions to allow it to generate the cash it needs when it needs it.

b. The massive borrowing activity during the 1980s would have manifested itself as increased

liabilities on the companies' balance sheets. By analyzing different companies' current ratios and debt/equity ratios, which are measures of a company's solvency, potential investors may have been able to identify those companies that were taking on an excessive amount of debt. However, even this type of analysis may not have been sufficient to identify overly risky companies. Companies will often engage in off-balance sheet financing, such as structuring leasing arrangements as an operating lease. Companies are most likely to engage in off-balance sheet financing when they are close to violating existing debt covenants that specify a maximum debt/equity ratio or when the company already has a large amount of debt. Since, by definition, off-balance sheet financing does not show up on the balance sheet as a liability, it will not be reflected in either the current ratio or the debt/equity ratio.

An alternative analysis strategy investors could have used was to examine the statement of cash flows to determine whether the company was consistently generating enough cash from operating activities to service its debt. This approach is good in that any cash payments associated with off-balance sheet financing will be reflected on the statement of cash flows. The negative aspect of this analysis approach is that the analysis cannot be adequately performed until the company is making interest and principal payments. By this time it may be too late!

c. A debenture is an unsecured bond. That is, there is no collateral supporting the bond. Thus,

should the company not repay the bonds, investors in debentures, unlike investors in secured bonds, do not have security in any of the company's assets that could be sold to repay the bonds. In other words, in the event a company liquidates, the secured creditors are paid before the unsecured creditors. This means that if the company does not have sufficient cash available after liquidating to repay both the secured creditors and the holders of debentures, it is the latter group that will not receive full payment.

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CHAPTER 11 LONG-TERM LIABILITIES: NOTES, BONDS, AND LEASES 9 Financing Decisions... · LONG-TERM LIABILITIES: NOTES, BONDS, AND LEASES ... During 2009 $9.375 million of interest expense