Professional Documents
Culture Documents
Test Bank For Financial Statement Analysis and Valuation 5th Edition by Easton Mcanally Sommers Zhang
Test Bank For Financial Statement Analysis and Valuation 5th Edition by Easton Mcanally Sommers Zhang
True/False
Answer: True
Answer: True
Rationale: Companies must estimate accrued liabilities such as rent payable because there has been
no bill received or no transaction.
Answer: False
Rationale: If the accrued liabilities in this period are overestimated, then the current income is lower
than it should be. This error will be corrected in a following period, and will artificially inflate income.
Answer: True
Rationale: Only ‘probable’ contingent liabilities are estimated and recorded on the balance sheet or
the income statement. Anything less than ‘probable’ liabilities (such as ‘reasonably possible’) are
referenced in footnotes.
Answer: False
Rationale: Only the principal portion is classified as “current portion of long-term debt.”
Answer: False
Rationale: This bond sells at a premium, not a discount.
Answer: False
Rationale: After the bonds are issued, they can trade in the secondary market just like stocks.
Answer: True
Rationale: Market prices fluctuate similar to stocks. The reasoning behind this is that bonds compete
with other investments and become more or less attractive based on the interest rates of competing
securities and the financial condition of the borrowing company.
Answer: False
Rationale: The coupon rate and the market rate are nearly always different. The coupon rate is fixed
prior to issuance of the bond and normally remains fixed throughout its life. Market rates of interest,
on the other hand, fluctuate continually with the supply and demand for bonds in the marketplace,
general macroeconomic conditions, and the borrower’s financial condition.
Answer: True
Answer: False
Rationale: The market rate of interest is usually defined as the yield on U.S. Government borrowings
such as treasury bills, notes, and bonds, called the risk-free rate, plus a spread (also called a risk
premium).
Answer: True
Rationale: The credit rating agencies provide an assessment of their view of the likelihood that a
company will default on its debt obligations.
Answer: True
Rationale: The market rate of interest is usually defined as the yield on U.S. Government borrowings
such as treasury bills, notes, and bonds, called the risk-free rate, plus a spread (also called a risk
premium).
Answer: False
Rationale: Higher credit-rated borrowers receive lower interest rates than lower credit-rated borrowers
and the difference is significant. For example, in March 2016, the average 10-year treasury bond yield
was 1.89%, while the Aaa corporate bond yield was 3.82% and the average Baa (the lowest
investment grade corporate bond) yield was 5.13%.
Answer: B and C
Rationale: Contingent liabilities are only included when the amount is probable and estimable. An
obligation that is guaranteed at some point in the future is a liability, and one for which the liability is
less than reasonably possible does not need to be reported.
Answer: D
Rationale: The sale of goods on credit impacts non-cash assets, specifically accounts receivable; all
the other items are liabilities that the company must pay within the next year, hence current liabilities.
Answer: A
Rationale: For a liability to be a contingent liability, the amount must be estimable and probable.
Answer: C
Rationale: Based on management’s belief, the lawsuit at hand can be deemed less than reasonably
possible and therefore does not need to be disclosed in the financial statements.
Answer: D
Rationale: Bonds are issued to raise capital with repayment of the principal amount on a specified
date in the future (more than one year from the point of issue); therefore, bonds are considered long-
term liabilities.
Answer: B
Rationale: $1,900 million x 4% x 30% = 22.8 million
How much did EZ Wheels pay during the year to repair and/or replace scooters under warranty?
A) 12.4 million
B) 22.8 million
C) 76.0 million
D) 26.7 million
E) None of the above
Answer: D
Rationale: Total cash paid out is $16.3 million + $22.8 million* - $12.4 million = $26.7 million.
*$1,900 million x 4% x 30% = 22.8 million (warranty expense)
Answer: C
Rationale: $360,000 × 5% × 15 / 365 days = $739.73
Answer: B
Rationale: $360,000 × 5% × 1 / 12 months = $1,500
Answer: A
Rationale: The quarterly interest charge is calculated by multiplying the loan amount ($92,000) by the
interest rate (4%) and then by the portion of the year outstanding (3/12), or $920 accrued interest.
The company needs to reflect the outstanding interest owed (accrued interest) by increasing liabilities
and increasing interest expense.
Answer: D
Rationale: Coupon rates are used to compute the dollar amount in interest payments paid to the
bondholder semiannually. Hudson pays $300,000 × 7% × ½ year = $10,500.
Answer: A
Rationale: Coupon rates are used to compute the dollar amount in interest payments paid to the
bondholder semiannually. Pinto pays $300,000 × 4% × ½ year = $6,000.
Answer: C
Rationale: For debt issued at a discount, interest expense reported on the income statement is cash
interest paid plus amortization of the discount.
Answer: A
Rationale: Using a financial calculator or Excel the present value of the bonds = $544,913
Calculator Excel
N = 10 Rate = 2%
I/Yr = 2 Nper = 10
PMT = -15,000 Pmt = -15,000
FV = -500,000 FV = -500,000
Type = 0
Answer: C
Rationale: Using a financial calculator or Excel the present value of the bonds = $640,289.
Calculator Excel
N = 10 Rate = 3%
I/Yr = 3 Nper = 10
PMT = -14,000 Pmt = -14,000
FV = -700,000 FV = -700,000
Type = 0
Answer: C
Rationale: Using a financial calculator or Excel, the semi-annual effective interest rate on the bonds
equals 2%, resulting in an annual effective rate of 4%.
Calculator Excel
N = 10 Nper = 10
PV = 490,222 Pmt = -13,500
PMT = -13,500 PV = 490,222
FV = -450,000 FV = -450,000
Type = 0
What is the bonds’ issue price assuming that the bonds’ market interest rate is 10% per year?
A) $ 950,000
B) $1,068,391
C) $ 626,485
D) $1,111,758
E) None of the above
Answer: B
Rationale: Using a financial calculator or Excel the present value of the bonds = $1,068,391
Calculator Excel
N = 20 Rate = 5%
I/Yr = 5 Nper = 20
PMT = -57,000 Pmt = -57,000
FV = -950,000 FV = -950,000
Type = 0
What is the bonds’ issue price assuming that the bonds’ market interest rate is 14% per year?
A) $ 748,714
B) $ 950,000
C) $ 751,788
D) $1,273,515
E) None of the above
Answer: A
Rationale: Using a financial calculator or Excel the present value of the bonds = $748,714
Calculator Excel
N = 20 Rate = 7%
I/Yr = 7 Nper = 20
PMT = -47,500 Pmt = -47,500
FV = -950,000 FV = -950,000
What amount in interest expense did InterTech record for the December 31, 2017 payment?
A) $153,725
B) $130,500
C) $156,625
D) $174,000
E) None of the above
Answer: A
Rationale: Using a financial calculator or Excel, the present value of the bond = $3,843,125
12/31 Interest expense = $3,843,125 × 0.04 = $153,725.
Calculator Excel
N = 16 Rate = 4%
I/Yr = 4 Nper = 16
PMT = -130,500 Pmt = -130,500
FV = -4,350,000 FV = -4,350,000
PV = 3,843,125.14 Type = 0
PV = 3,843,125.14
What amount in interest expense did InterTech record for the June 30, 2018 payment?
A) $130,500
B) $154,654
C) $174,000
D) $157,671
E) None of the above
Answer: B
Rationale: Using a financial calculator or Excel, the present value of the bond = $3,843,125
12/31 Interest expense = $3,843,125 × 0.04 = $153,725
06/30 Interest expense = ($3,843,125 + $23,225*) × 0.04 = $154,654
*Discount amortization = $153,725 - $130,500
Calculator Excel
N = 16 Rate = 4%
I/Yr = 4 Nper = 16
PMT = -130,500 Pmt = -130,500
FV = -4,350,000 FV = -4,350,000
PV = 3,843,125.14 Type = 0
PV = 3,843,125.14
Answer: C
Rationale: Credit ratings affect the bond’s yield but not the coupon payments determined by the
issuer.
Answer: D
Rationale: $75,000 paid – $68,200 book value = $6,800 net gain on redemption
What is the gain or loss that Washington Inc. would report for the retirement of this bond?
A) $20,000 gain
B) $14,100 loss
C) $20,000 loss
D) $14,100 gain
E) None of the above
Answer: C
Rationale: Net book value = ($705,000 × 0.98) + $8,200 = $699,100
Gain (loss) = $699,100 – ($705,000 × 1.02) = $(20,000)
Answer: C
Rationale: The probability a company will make timely payments, that is, the potential risk of default.
Bond investors are primarily concerned with a company’s ability to make interest and principal
payments per the bond agreement.
Answer: D
Rationale: As debt quality moves from AAA to C, the market interest rate required increases. So, the
required rate decreases from C to AAA.
Answer: E
Rationale: Industry characteristics, capital structure, management, and profitability all play a role in
determining a company’s credit rating.
Answer: B
Rationale: The risk premium can be found by subtracting the risk-free rate from the yield rate:
(6.24% – 4.88% = 1.36%).
Answer: B
Rationale: The risk-free rate is the yield on U.S. Government borrowings such as treasury bills, notes,
and bonds.
Answer: E
Rationale: Moody’s considers many factors in deriving a credit rating, including profitability ratios,
covenants, solvency ratios, and collateral.
a. Nike, Inc. agreed to purchase materials for its new line of running shoes in June 2017.
b. Nike, Inc. signed a 60-day 8% note for $105,000 on May 12, 2017 to finance its seasonal working
capital needs. Principal and interest are due on July 11, 2017.
c. Nike, Inc. owes $180,000 at year-end for inventory purchases.
d. Nike, Inc. received a $250,000 deposit from Foot Locker for an order on the new line of running
shoes that will be ready for shipment in September 2017.
Answer:
a. Not recorded as a liability, the transaction is happening next month.
c. $180,000 is recorded in accounts payable (current operating liability) on the balance sheet.
d. $250,000 is recorded as deferred revenue, an accrued liability (current operating liability) on the
balance sheet.
Use the financial statement effects template below to record these transactions.
Sell computers = – =
Record cost of
= – =
goods sold
+96,000
+96,000
Sell computers +96,000 = (Retained – = +96,000
(Sales)
Earnings)
-60,000
Record cost of -60,000 +60,000
= (Retained – = -60,000
goods sold (INV) (COGS)
Earnings)
-60,000
Pay for computers -60,000 = – =
(AP)
Answer:
a. EZ Wheels should record the expected cost of warranties in the same period that sales revenue
is recognized. The amount is recorded as a warranty expense in the income statement and as a
liability on the balance sheet. The warranty liability should reflect the estimated cost that the
company expects to incur as a result of warranty claims and can be estimated based on past
experience.
c. During the year, the accrued warranty liability decreased. This means that EZ Wheels paid out
more to replace or repair warrantied goods than the expense the company recorded. Total cash
paid out is $15.4 million + $25.2 million - $11.5 million = $29.1 million.
Answer:
Interest expense = $45,000 × 4% × (6/12) = $900
The $900 should be recorded as an increase in current liabilities (interest payable) and an increase in
expenses (interest expense) on the income statement.
Answer:
a. $36,000 × 0.08 × 41 days / 365 days = $323.51
Use the financial statement effects template below to record the bond issue and InterTech’s first two
interest payments.
Bond issue = – =
Interest 12/31 = – =
Interest 6/30 = – =
Bond issue price: Using a financial calculator or Excel, the present value of the bond = $3,047,996
Calculator Excel
N = 16 Rate = 4%
I/Yr = 4 Nper = 16
PMT = -103,500 Pmt = -103,500
FV = -3,450,000 FV = -3,450,000
Type = 0
12/31 Interest expense = $3,047,996 × 0.04 = $121,920. Bond net book value increases by the
difference of $18,420.
6/30 Interest expense = ($3,047,996 + $18,420) × 0.04 = $122,657. Bond net book value increases
by the difference of $19,157.
= – =
1)
2) = – =
3)
4)
5) = – =
-720,000
-255,000 +720,000
2) -975,000 = (Retained – = -720,000
(LTD) IE(2)
earnings)
-709,800
-975,000 -265,200 +709,800
3) = (Retained -709,800
(LTD) IE(3)
earnings)
-699,192
-975,000 -275,808 +699,192
4) = (Retained -699,192
(LTD) IE(4)
earnings)
-688,160
-975,000 -286,840 +688,160
5) = (Retained – = -688,160
(LTD) IE(5)
earnings)
(1) Received $18 million cash from loan proceeds and recorded the $18 million liability.
(2) 0.04 × $18,000,000 = $720,000 interest expense. The difference between the installment cash payment and the interest
expense is the repayment of principal.
(3) 0.04 × ($18,000,000 - $255,000) = $709,800 interest expense. The difference between the installment cash payment and
the interest expense is the repayment of principal.
(4) 0.04 × ($18,000,000 - $255,000 - $265,200) = $699,192 interest expense. The difference between the installment cash
payment and the interest expense is the repayment of principal.
(5) 0.04 × ($18,000,000 - $255,000 - $265,200 - $275,808) = $688,160 interest expense. The difference between the
installment cash payment and the interest expense is the repayment of principal.
Answer:
a. Using a financial calculator or Excel the present value of the bonds = $843,467
Calculator Excel
N = 20 Rate = 5%
I/Yr = 5 Nper = 20
PMT = -45,000 Pmt = -45,000
FV = -750,000 FV = -750,000
Type = 0
b. Using a financial calculator or Excel the present value of the bonds = $670,545
Calculator Excel
N = 20 Rate = 7%
I/Yr = 7 Nper = 20
PMT = -45,000 Pmt = -45,000
FV = -750,000 FV = -750,000
Type = 0
Answer:
Using a financial calculator or Excel the present value of the bonds = $5,037,089
Calculator Excel
N = 10 Rate = 4%
I/Yr = 4 Nper = 10
PMT = -183,750 Pmt = -183,750
FV = -5,250,000 FV = -5,250,000
Type = 0
Answer:
a. Using a financial calculator or Excel the present value of the bonds = $1,152,087
Calculator Excel
N=5 Rate = 8%
I/Yr = 8 Nper = 5
PMT = -84,000 Pmt = -84,000
FV = -1,200,000 FV = -1,200,000
Type = 0
b. Using a financial calculator or Excel the present value of the bonds = $1,061,009
Calculator Excel
N = 10 Rate = 5%
I/Yr = 5 Nper = 10
PMT = -42,000 Pmt = -42,000
FV = -1,200,000 FV = -1,200,000
Type = 0
Answer:
Amount to retire bonds = $500,000 × 0.96 = $480,000
Bond book value = $475,000
Loss on bond retirement = $480,000 - $475,000 = $5,000
Answer:
$66,000 paid – $59,200 book value = $6,800 net loss on redemption
Answer:
Gain (loss) on bond repurchase = Net book value of bonds - Repurchase payment
Gain (loss) = $457,500 – (96% of the bond face value) = $457,500 – $475,200 = $(17,700)
Loss = $17,700
Calculate the net book value of the bond on January 1, 2017 and the gain or loss that Washington
Inc. would report for this retirement.
Answer:
Net book value = Bond proceeds at issuance + discount amortization.
Net book value = ($675,000 × 0.98) + $7,500 = $669,000
Gain (loss) = Net book value – Cash to retire bonds.
Gain (loss) = $669,000 – ($675,000 × 1.03) = $(26,250). Washington must report a loss of $26,250
on the bond retirement.
Using the partial listing of ratios utilized by Moody’s Investors Services along with the median
averages for the various ratings, estimate the credit rating that Moody’s might assign to Weiss
Corporation.
Answer:
Financial Ratio Result Rating
Operating margin 13.8% Baa
Debt/EBITDA 1.5 A
FFO/Debt 21.9% Ba
EBITA/Interest expense 6.9 Baa
CAPEX/Depreciation expense 1.2 Baa-Ba
Revenue volatility 10.8 A-Baa
Overall rating Baa
Environmental Matters
The Company believes that there are no compliance issues associated with applicable
environmental laws and regulations that would have a material adverse effect on the
Company. The Company is also remediating environmental contamination resulting from past
industrial activity at certain of its sites. Expenditures for remediation and environmental
liabilities were $11 million in 2016, and are estimated at $44 million in the aggregate for the
years 2017 through 2021. These amounts do not consider potential recoveries from other
parties. The Company has taken an active role in identifying and accruing for these costs and
in management’s opinion, the liabilities for all environmental matters that are probable and
reasonably estimable have been accrued and totaled $83 million and $109 million at
December 31, 2016 and 2015, respectively. These liabilities are undiscounted, do not
consider potential recoveries from other parties and will be paid out over the periods of
remediation for the applicable sites, which are expected to occur primarily over the next
15 years. Although it is not possible to predict with certainty the outcome of these matters, or
the ultimate costs of remediation, management does not believe that any reasonably possible
expenditures that may be incurred in excess of the liabilities accrued should exceed $64
million in the aggregate. Management also does not believe that these expenditures should
result in a material adverse effect on the Company’s financial position, results of operations,
liquidity, or capital resources for any year.
Required:
a. How does Merck account for environmental liabilities that are probable and reasonably
estimable? At December 31, 2016, how much were these liabilities?
b. How does Merck account for environmental liabilities that are reasonably possible? At December
31, 2016, how much were these liabilities?
c. The footnote mentions $83 million and $44 million as estimated future expenditures. Explain what
each of these amounts represents and why they differ.
d. Use the financial statement effects template below, to record Merck’s 2016 remediation and
environmental expenditures, assuming that the liability had already been accrued on Merck’s
books.
b. Merck does not accrue a liability for environmental costs that are reasonably possible. Instead,
Merck discloses these potential future payments in a footnote. At December 31, 2016, these
liabilities amounted to an additional $64 million.
c. The $83 million is the total accrual on Merck’s balance sheet at year end. The $44 million is the
amount that Merck anticipates paying out in the coming five years (2017 to 2021). The difference
of $39 million will be paid in 2022 and later.
d.
Balance Sheet Income Statement
2016 2015
5.125% Notes, due 2019 $ 947 $ 947
2.35% Notes, due 2019 2,850 —
4.125% Notes, due 2020 597 597
2.00% Notes, due 2020 750 750
2.90% Notes, due 2021 2,850 —
2.55% Notes, due 2022 750 750
3.40% Notes, due 2023 1,500 —
2.95% Notes, due 2025 1,000 1,000
3.75% Notes, due 2026 3,000 —
4.75% Notes, due 2036 1,650 —
6.15% Notes, due 2037 547 547
6.0% Notes, due 2039 515 515
5.3% Notes, due 2040 694 694
4.90% Notes, due 2046 3,250 —
Unamortized debt issuance costs (117) (21)
Other, including fair value adjustments relating to interest
rate hedge contracts designated as fair value hedges (102) 92
Total, net of current maturities 20,681 5,871
Current maturities of long-term debt 3 3
Total carrying amount $ 20,684 $ 5,874
Principal payments required on long-term debt outstanding at December 31, 2016 are
$3 million in 2017, $2 million in 2018, $3.8 billion in 2019, $1.3 billion in 2020, $2.9 billion in 2021
and $12.9 billion in 2022 and thereafter.
At December 31, 2016, Abbott's long-term debt rating was A+ by Standard & Poor's
Corporation and A2 by Moody's Investors Service. In conjunction with the completion of the
St. Jude Medical acquisition on January 4, 2017, the ratings were adjusted to BBB by Standard &
Poor's Corporation and Baa3 by Moody's Investors Service. Abbott has readily available financial
resources, including unused lines of credit of $5.0 billion which expire in 2019 and that support
commercial paper borrowing arrangements. Abbott's weighted-average interest rate on short-
term borrowings was 0.6% at December 31, 2016 and 0.2% at December 31, 2015 and 2014.
Required:
a. What proportion of long-term debt will Abbott Labs repay in 2017?
b. How much does the company owe under the line of credit at year end? Why does Abbott Labs
discuss this in its debt footnote?
c. How did the acquisition of St. Jude Medical impact Abbott Labs’ default risk?
Answer:
a. Abbott Labs will repay 0.0145% of its long-term debt in 2017 ($3 / $20,684 = 0.000145).
b. Abbott Labs does not owe anything under the line of credit at year end. The $5 billion line of
credit ensures that the company has easy access to significant amounts of cash if the need
arises. This reduces liquidity risk to investors and creditors, which could reduce Abbott Labs’ cost
of capital.
c. Prior to the acquisition of St. Jude Medical, Abbott’s corporate debt was rated A+ and A2 by
Standard & Poor’s and Moody’s Investors Services as of December 31, 2016. In November
2016, Abbott issued $15.1 million in debt to fund the cash portion of the acquisition of St. Jude
Medical. As a result, Abbott’s total 2016 long-term debt balance increased by 3.5 times its 2015
year-end balance. After the acquisition was complete, S&P and Moody’s downgraded Abbott’s
corporate debt to BBB and Baa3, respectively. The credit rating agencies determined that
Abbott’s default risk had increased with the acquisition of St. Jude’s Medical and with the
substantial increase in long-term debt.
*For purposes of this exercise, assume the entire debt amount is long-term.
Required:
a. Explain in layman’s terms the liabilities labeled “Unearned premiums” and “Loss reserves.”
b. What percentage of Progressive’s total liabilities relates to current operating liabilities for 2016?
Do you believe that this number is higher than most companies or lower? Why?
c. Which current liability reported by Progressive is the least reliably measured – that is, the most
subjective? Explain.
Answer:
a. Unearned premiums are cash premiums received from customers for future insurance coverage.
These premiums cover the future and thus Progressive has not earned them yet – they represent
a liability until time passes and the premiums are earnings.
Loss reserves are anticipated payments for claims made under current insurance policies. These
future payments are liabilities now because they arise from insurance coverage during the current
and past years. As the company recognizes premiums as revenue, the company estimates how
many claims will arise from current insurance policies and accrues the eventual (estimated)
payments. This is evidence of the matching principle.
c. The loss reserve is the anticipated future payments and is the most subjective current liability on
Progressive’s balance sheet. To estimate the reserve, Progressive must estimate the number of
claims that will be made, the amount that will be ultimately paid out, and the timing of such future
payments. Such estimates are very difficult to audit.
Unearned premiums are more reliable (less subjective) because cash prepayments can be
verified and insurance policy terms are easy to confirm and the unearned premium calculation is
straight forward.
Accounts payable are more reliably measured because they are typically recorded when bills
received or shipping documents arrive with goods. Accrued expenses are more subjective than
accounts payable but likely less subjective than loss reserves.
2016 2015
Carrying Fair Carrying Fair
(millions) Value Value Value Value
3.75% Senior Notes due 2021 (issued: $500.0, August 2011) $ 498.4 $528.8 $498.1 $528.7
2.45% Senior Notes due 2027 (issued: $500.0, August 2016) 495.8 464.6 0 0
6 5/8% Senior Notes due 2029 (issued: $300.0, March 1999) 295.9 380.1 295.7 376.0
6.25% Senior Notes due 2032 (issued: $400.0, November 2002) 395.2 499.0 395.0 490.6
4.35% Senior Notes due 2044 (issued: $350.0, April 2014) 346.4 362.3 346.4 352.8
3.70% Senior Notes due 2045 (issued: $400.0, January 2015) 395.1 372.5 395.0 362.0
6.70% Fixed-to-Floating Rate Junior Subordinated Debentures
due 2067 (issued: $1,000.0, June 2007; outstanding: $594.6
and $614.4) 594.1 581.2 612.8 612.8
Other debt instruments 127.3 127.3 164.9 164.9
During 2016, we renewed the unsecured, discretionary line of credit (the "Line of Credit") with PNC
Bank, National Association (PNC) in the maximum principal amount of $100 million. The prior line of
credit, entered into in March 2015, had expired. The Line of Credit is on substantially the same terms
and conditions as the prior line of credit. Subject to the terms and conditions of the Line of Credit
documents, advances under the Line of Credit (if any) will bear interest at a variable rate equal to the
higher of PNC's Prime Rate or the sum of the Federal Funds Open Rate plus 50 basis points. Each
advance must be repaid on the 30th day after the advance or, if earlier, on April 30, 2017, the
expiration date of the Line of Credit. Prepayments are permitted without penalty. All advances under
the Line of Credit are subject to PNC's discretion. We had no borrowings under the Line of Credit or
the prior line of credit in 2016 or 2015.
(in millions)
Year Payments
2017 $25.0
2018 25.0
2019 11.3
2020 0.8
2021 500.0
Thereafter 2,609.8
Total $3,171.9
Answer:
a. Progressive reports the carrying value (net book value) of long-term debt on its balance sheet. As
of December 31, 2016 this was $3,148.2 million.
b. Carrying value and fair value differ because the prevailing market rates of interest are lower than
the notes’ coupon (stated) interest rate. Thus, the fair value of the notes is more than their net
book value.
c. The 3.75% notes were originally issued at a discount because the carrying value increased in
2016 to 498.4 from 498.1 as the discount amortization is added to the carrying value and the
carrying value is less than the face value of 500 million.
d. The unamortized discount on the 6.25% notes as of December 31, 2016 is $4.8 million ($400
million – $395.2 million).
e. Progressive paid cash interest of $19.875 million for the 6 5/8% notes ($300 million × 6 5/8 %).
The interest expense for these notes was $20.075 million. Interest expense on a bond issued at a
discount = cash interest paid + amortization of bond discount. During the year, the bond’s
carrying value increased by $0.2 million, (from $295.7 million to $295.9 million). Therefore,
interest expense = $19.875 million + $0.2 million = $20.075 million.
f. Because the market value of Progressive’s notes is more than its book value, Progressive will
have to report this difference as a loss on the income statement when it repurchases the bonds.
g. Progressive does not owe anything under the line of credit at year end. The $100 million line of
credit ensures that the company has easy access to significant amounts of cash if the need
arises. This reduces liquidity risk to investors and creditors, which could reduce Progressive’s
cost of capital.
h. The footnote reveals that there is $25.0 million of long-term debt due in 2017, $25 million due in
2018, $11.3 million due in 2019, $0.8 million due in 2020, and $500 million due in 2021. $2,609.8
million of long-term debt is due sometime after 2021.
Use the table below to show the amortization of the discount, interest expense, and the carrying
amount of the bonds from issuance till the end of Period 4.
Answer:
Interest Cash Discount Discount Bond
Expense Interest Paid Amortization Balance Payable, net
0 2,203,701 37,796,299
1 2,456,759 2,400,000 56,759 2,146,942 37,853,058
2 2,460,449 2,400,000 60,449 2,086,493 37,913,507
3 2,464,378 2,400,000 64,378 2,022,115 37,977,885
4 2,468,563 2,400,000 68,563 1,953,552 38,046,448
Required:
a. What is the amount of debt on Lowe’s balance sheet as of February 3, 2017?
b. What proportion of Lowe’s long-term debt is due before February 2, 2018?
c. How much of Lowe’s assets were pledged as collateral as of February 3, 2017?
d. What effect, if any, does Lowe’s collateral have on its credit risk and interest costs?
e. Assume that the notes due fiscal 2042-2046 outstanding at the beginning of the year were 4.26%
notes issued to yield 4.4%. At the beginning of the year, these notes had an unamortized
discount of $132 million. What cash interest payment did Lowe’s make for these notes, assuming
interest is paid annually? What interest expense did Lowe’s record for these notes during the
current year?
Answer:
a. Total debt at February 3, 2017 was $15,189 million.
b. Current portion is $795 million which is 5.23% of total debt outstanding ($795 / $15,189).
d. To the extent debt is secured, the debt holder is in a preferred position relative to other creditors.
The interest costs should be less to reflect the reduced credit risk.
e. Interest expense = Net book value of debt × effective interest rate = $2,301 million × 0.044
= $101.2 million.
Cash paid for interest = Face value of debt × coupon rate = ($2,301 million + $132 million) ×
0.0426 = $103.6 million.
© Cambridge Business Publishers, 2018
7-31 Financial Statement Analysis & Valuation, 5th Edition
Essay Questions
Answer:
The allowance relates to anticipated payments for future insurance claims. This is a liability now
because the future claims arise from insurance coverage during the current and prior years. Because
loss reserves are the anticipated future payments, the number on the balance sheet is very
subjective. To estimate the reserve, Progressive must estimate the number of claims that will be
made, the amount that will be ultimately paid out, and the timing of such future payments. Such
estimates are very difficult to audit. This makes it easy for Progressive’s managers to manipulate the
reserve number.
If managers want to increase current period income they could underestimate the reserve. This would
boost net income because the loss expense would be lower. Then in the next period, the losses
would be more than the accrual and next period earnings would decrease. For example, if managers
deliberately underestimated the reserve by $90 million (accruing $11,278 million instead of $11,368.0
million) then 2016 income before tax would be higher by $90 million and 2017 or other future years’
income before tax would be lower by that amount.
Answer:
A contingent liability is an uncertain accrual. The obligation must be “probable” and the amount
“estimable” in order to require reporting on the face of the financial statements.
A company would like to keep its contingent liability as low as possible as it appears on the balance
sheet of a company as a liability. If the accruals are underestimated, it means that the income and
retained earnings are overestimated.
As a company can determine the amount of its contingent liability and whether it’s “probable” or
“reasonably possible”, it could choose to aggressively recognize these as part of a “big bath” to
relieve future periods of expense or provide a cookie jar if the expenses are overestimated.
Answer:
The effective cost of debt is determined by the price at which a bond is issued. If a bond is issued at
par, its effective cost of debt is the cash interest paid. However in many cases debt is either issued at
a discount or a premium. The effective cost of debt is always equal to the market rate of interest,
regardless of the debt’s coupon rate. It is the amount that is reported on the issuer’s income
statement as interest expense, and it is usually different from cash interest paid.
Answer:
GAAP recognizes a gain (loss) on debt repurchase as the carrying amount of the debt less the
repurchase price. The gain or loss on repurchase is exactly offset by the present value of the future
cash flow implications of the repurchase and as a result, there is no economic gain (loss).
Gains (losses) are nonoperating and transitory and, consequently, will not be repeated in future
income statements. For analysis purposes, they have no economic substance.
Current values for debt issues are not reflected on the balance sheet, and hence the income
statement, due to the presumption that debt will not be retired prior to maturity and, at maturity, its
market value will equal the face amount that will be repaid.
Answer:
Investors use a number of critical ratios when determining the different classes of risk, including:
• Collateral – security provided on debt; the extent the debt is secured impacts on the position
a debtholder has regarding repayments of debt
• Covenants – restrictions enforced by debtholders on a company
• Options – ability of debtholder to convert debt to stock or the allowance of a company to
repurchase the debt prior to maturity.
Answer:
Default is the nonpayment of interest and principal of the bond. If a company defaults on its debt,
bondholders may force the company into bankruptcy and require asset liquidation to settle debt
obligations. Default often leaves the bondholder with a loss. The analysis of the risk of nonpayment is
the work that goes into pricing bonds. S&P uses financial ratios related to a company’s liquidity,
profitability, and solvency to determine a company’s ability to pay its debt.