Solutions for Exam 1 Class Problems, Chapters 2,3,5,6 and 8
E2-31 (15 minutes)
a.
Proctor & Gamble ($ millions)
Amount
Classification
Sales ......................................................................
$ 83,503
I
Accumulated depreciation ..................................
17,446
B
Depreciation expense ..........................................
3,166
I
Retained earnings ................................................
48,986
B
Net income ............................................................
12,075
I
Property, plant and equipment ...........................
20,640
B
Selling, general and admin expense ..................
25,725
I
Accounts receivable ............................................
6,761
B
Total liabilities ......................................................
74,498
B
Stockholders' equity ............................................
69,494
B
b. Total Assets = Total Liabilities + Stockholders’ Equity
Total Assets = $74,498 + $69,494 = $143,922
Sales – Total Expenses = Net Income
$83,503 – Total Expenses = $12,075
Thus, Total Expenses = $71,428
c. Net Profit Margin = Net income/Sales = $12,075/$83,503
Net Profit Margin = 14.46%
Total Liabilities-to-Equity Ratio = Total Liabilities/Stockholders’ Equity
Total Liabilities-to-Equity Ratio = $74,498/$69,494 = 1.07
E2-32 (15 minutes)
a.
Target Corp ($ millions)
Amount
Classification
Sales ........................................................................
$ 61,471
I
Accumulated depreciation ....................................
7,887
B
Depreciation expense ............................................
1,659
I
Retained earnings ..................................................
12,761
B
Net income ..............................................................
2,849
I
Property, plant & equipment ................................
24,095
B
Selling, general & admin expense ........................
13,704
I
Accounts receivable ..............................................
8,054
B
Total liabilities ........................................................
29,253
B
Stockholders' equity ..............................................
$ 15,307
B
b. Total Assets = Total Liabilities + Stockholders’ Equity
Total Assets = $29,253 + $15,307 = $44,560
Total Revenue – Total Expenses = Net Income
$61,471 – Total Expenses = $2,849
Thus, Total Expenses = $58,622
c. Net Profit Margin = Net income / Sales
Net Profit Margin = $2,849 / $61,471 = 4.63%
Total Liabilities-to-Equity Ratio = Total Liabilities / Stockholders’ Equity
Total Liabilities-to-Equity Ratio = $29,253 / $15,307 = 1.91
M3-15 (30 minutes)
April 1
Cash
Common Stock
9,000
9,000
Owner invested cash for stock.
2
Prepaid Van Lease
Cash
2,850
2,850
Paid six months' lease on van.
3
Cash
Notes Payable
10,000
10,000
Borrowed money from bank for one
year, interest rate is 10%.
4
Equipment
Cash
Accounts Payable
5,500
2,500
3,000
Purchased $5,500 of equipment; paid
$2,500 cash with balance due in 30 days.
5
Supplies
Cash
4,300
4,300
Purchased supplies for cash.
7
Advertising Expense
Cash
350
350
Paid for April advertising.
21
Accounts Receivable
Cleaning Fees Earned
3,500
3,500
Billed customers for services.
23
Accounts Payable
Cash
3,000
3,000
Payment on account.
28
Cash
Accounts Receivable
2,300
2,300
Collections from customers on account.
29
Dividends
Cash
1,000
1,000
Paid cash dividends.
30
Wages Expense
Cash
1,750
1,750
Paid wages for April.
30
Van Fuel Expense
Cash
995
995
M3-15—continued.
April 1
3
28
Cash
9,000 2,850
10,000 2,500
2,300 4,300
350
3,000
1,000
1,750
995
April 5
Supplies
4,300
April 23
Accounts Payable
3,000 3,000
April 2
4
5
7
23
29
30
30
April 21
Accounts Receivable
3,500 2,300
April 2
Prepaid Van Lease
2,850
April 4
Equipment
5,500
Notes Payable
10,000
April 4
April 29
Common Stock
9,000
April 7
Advertising Expense
350
April 30
Van Fuel Expense
995
April 30
April 3
Dividends
1,000
Cleaning Fees Earned
3,500
April 1
April 28
Wages Expense
1,750
April 21
M5-19 (15 minutes)
a. Basic earnings per share is computed as net income less any preferred
dividends, divided by the weighted average number of common shares
outstanding for the period.
The diluted earnings per share calculation includes the effect of dilutive
securities (such as convertible debt securities or employee stock
options) in the denominator and adjusts for any effects of conversion or
exercise in the numerator.
Consequently, diluted earnings per share is always less than or equal to
basic earnings per share.
b. Shares (denominator): For the shares computation, Goodyear has
200,933,767 weighted average common shares outstanding, and
231,717,930 shares outstanding for the diluted EPS computation. The
additional 30,784,163 weighted average dilutive common shares
(26,673,721 + 4,110,442) relate to employee stock options, stock
warrants (similar to options), and convertible securities (such as
convertible debt and convertible preferred stock) that potentially could
be converted into common shares.
Income (numerator): Goodyear’s net income of $602 million is the
numerator for the basic EPS computation. Goodyear’s adjusted income
is $13 million higher, or $615 million, for the diluted EPS computation.
Basic EPS = $602 million / 201 million shares = $3.00
Diluted EPS = $615 million / 232 million shares = $2.65
c. Diluted EPS assumes that all convertible securities are converted at the
beginning of the year (or when issued if issued during the year). If the
debt was converted into common stock, Goodyear would not have
recorded interest expense relating to the convertible securities. Thus,
pretax income and tax expense would both have been higher. The $13
million is the after-tax income interest expense, which is added to
Goodyear’s reported profit of $602 million, in the EPS computation.
P5-35 (60 minutes)
a. SALES – revenue is normally earned when title to the product passes to
the customer who either purchases the product for cash or on credit
terms.
SERVICES, OUTSOURCING AND RENTALS – revenue from services is normally
earned as the service is performed, usually ratably over the service
contract period. The same applies to outsourcing and rentals.
FINANCE INCOME – revenue from finance income (normally interest) is
earned with the passage of time. For example, each period, Xerox
accrues interest on its loans and leases.
b. Research and development (R&D) expenses are expensed as incurred
under GAAP. Salaries for researchers are expensed like other salaries,
but are reported as R&D expense rather than SG&A expense. Long-term
R&D assets (buildings and equipment) that have no further use in
alternative projects are also expensed as R&D. General purpose R&D
assets are capitalized and depreciated like other depreciable assets. The
depreciation expense is reported as R&D rather than as depreciation or
SG&A.
P5-35 (continued)
c. 1. Restructuring costs typically fall into three general categories. (i)
accrual of liabilities for items, such as employee severance
payments, (ii) gains or losses from the write-off of assets, such as
plant assets and goodwill, and (iii) other restructuring and exit costs
including legal fees and costs to cancel contracts such as leases.
2. These restructuring costs are expensed in the current period despite
the fact that the impaired assets may not be formally written off and
the employees not paid their severance until future periods. In any
event, most analysts treat restructuring costs as transitory (one-time
occurrences). Accordingly, while restructuring costs should impact
the analysis, they typically do not affect the analysis to the same
degree as more persistent items such as recurring revenues and
expenses.
1. Some companies regularly report restructuring costs. Many analysts
treat these costs as recurring operating expenses and do not
consider them to be transitory items. This treatment implies that
these costs are more persistent in nature.
2. Negative expense typically implies that an accrual in one or more
previous year(s) is overstated and the company is reversing the
overstatement in the current year. As a result, the previous year’s
expense was overstated, thus underestimating profit for that year.
d. The tax benefit is a one-time event. Since it will not recur, it should be
excluded in projections of the future performance of the company.
Specifically, its income statement should be reformulated to show $338
in tax expense, computed as the $(5) reported plus the $343 in tax
benefits. The $343 in tax benefits could be allocated to the 1996-1998
periods, if these periods are part of the analysis.
e. Companies are not required to separately disclose revenue and
expense items unless they are deemed to be material. If not separately
disclosed, these items are aggregated with other immaterial items. Such
aggregation generally reduces the informativeness of income
statements. More problematic is that revenues and expenses can be
comingled in this “other” category to yield a small (net) number that
obscures the magnitude of the individual items comprising this
category. (Beware of companies that might net recurring operating
losses with nonrecurring nonoperating gains, yielding an immaterial
amount for “other.”)
E 6-22 (20 minutes)
a. 2009 bad debts expense computation
$90,000  1%
20,000  2%
11,000  5%
6,000  10%
4,000  25%
=
=
=
=
=
Less: Unused balance before adjustment
Bad debt expense for 2009
$ 900
400
550
600
1,000
$3,450
520
$2,930
b.
Balance Sheet
Income Statement
Transactio Cash
Noncash
Liabil- Contrib. Earned RevExpenNet
+
=
+
+
–
=
n
Asset
Assets
ities Capital Capital enues
ses
Income
BDE
2,930
AU
2,930
-2,930
BDE
2,930
Record bad
debt expense
AU
Allowance for
Uncollectible
Accounts
=
-2,930
Retained
Earnings
–
+2,930
Bad Debt
Expense
= -2,930
2,930
c. Accounts receivable, net = $131,000 - $3,450 = $127,550
Reported in the balance sheet as follows:
Accounts receivable, net of allowance of $3,450 .......................
$127,550
E 6-24 (25 minutes)
a,b.
($ millions)
2007
Accounts receivable (net) ...................................
$13,420
Allowance for uncollectible accounts ...............
2006
$10,873
226
220
Gross accounts receivable .................................
$13,646
$11,093
Percentage of uncollectible accounts
1.66%
1.98%
to gross accounts receivable ..........................
($226/$13,646) ($220/$11,093)
c.
($ millions)
2007
2006
2005
Bad debt expense ................................................ $32
$37
$17
Amounts actually written off .............................. $29
$48
$76
The provision (increase in the allowance account arising from bad debt
expense recorded on the income statement) increased from 2005
following the high write-offs in that year. The receivables that the
company wrote off have been declining. Over the three year period, HP
accrued $86 million ($32 + $37 + $17) of bad debt expense and wrote off
$153 million ($29 + $48 + $76) of uncollectible accounts receivable.
d. The allowance for uncollectible accounts has decreased as a percentage
of gross accounts receivable from 1.98% in 2006 to 1.66% in 2007 (see
part b). One way to gauge the adequacy of the allowance account is to
look at write-offs as a percentage of the allowance account at the
beginning of the year. In 2006, this percentage is 21.1% ($48/$227) and
for 2007 it is 13.2% ($29/$220). HP’s write-offs as a percentage of the
allowance decreased from 2006 to 2007. This means that the bad debt
expense is keeping up with actual accounts that go bad. Further insight
might be gained by comparing HP’s allowance account to those of its
peers.
E6-27 (30 minutes)
Units
Beginning Inventory
1,000
Purchases: #1
1,800
#2
800
#3
1,200
Goods available for sale 4,800
Cost
$ 20,000
39,600
20,800
34,800
$115,200
Units in ending inventory = 4,800 – 2,800 = 2,000
a.
First-in, first-out
Units
Ending Inventory
Cost
1,200
800
2,000
@
@
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
Total
$29
$26
=
=
$34,800
20,800
$55,600
$115,200
55,600
$ 59,600
Balance Sheet
Transaction
Cash Noncash
+
=
Asset Assets
Income Statement
Liabil
Contrib. Earned RevExpenNet
- +
+
–
=
Capital Capital enues
ses
Income
ities
COGS 59,600
INV
59,600
Record FIFO
cost of goods
sold
COGS
59,600
-59,600
-59,600 =
Inventory
Retained
Earnings
INV
59,600
b.
Last-in, first-out
Units
Ending inventory
Cost
1,000
1,000
2,000
Total
@
$20
@
$22
Cost of goods available for sale
Less: Ending inventory
Cost of goods sold
$115,200
42,000
$ 73,200
= $20,000
= 22,000
$42,000
+59,600
–
Cost of
Goods
Sold
=
-59,600
E6-27—continued
c.
Average cost
$115,200 / 4,800 = $24 average unit cost
2,000 × $24 = $48,000 ending inventory
$115,200 - $48,000 = $67,200 cost of goods sold (or 2,800 × $24)
d. 1. In most circumstances, the first-in, first-out method represents
physical flow. First-in, first-out physical flow is critical when inventory
is perishable or in situations in which the earliest items acquired are
moved out first because of risk of deterioration or obsolescence such
as technology products and retail items.
2. Last-in, first-out yields the highest cost of goods sold expense during
periods of rising unit costs, which in turn, results in the lowest taxable
income and the lowest income tax.
3. The first-in, first-out method results in the lowest cost of goods sold,
and the largest amount of income, in periods of rising prices. Of
course, this assumes that prices will continue to rise as they have in
the past. Companies cannot change inventory costing methods
without justification, and the change may be restricted by tax laws as
well.
E6-28 (25 minutes)
a. GE’s 2007 balance sheet reports $12,834, which is the LIFO inventory
value.
b. GE’s 2007 balance sheet would have reported $13,457, which is the FIFO
inventory value.
c. Pretax income has been reduced by $623 million ($13,457 million $12,834 million) cumulatively since GE adopted LIFO inventory costing.
This is because LIFO matches more “current” inventory costs against
current selling prices, thus avoiding the recognition of holding gains
that would have resulted had FIFO inventory costing been used.
d. Pretax income has been reduced by $623 million (see part c). Assuming
a 35% tax rate, taxes have been reduced by $623 × 0.35 = $218 million.
Accordingly, GE’s cumulative taxes have been decreased from the use
of LIFO inventory costing.
e. For 2007 only, the LIFO reserve increased by $59 million ($623 million $564 million). 2007 pretax income is $59 million lower, relative to what it
would have been with the FIFO method, thus reducing taxes by $20.65
million ($59 million × 0.35).
E6-35 (15 minutes)
$ millions
a. Average useful life = Depreciable asset cost / Depreciation expense
= ($6,992 - $83 - $245) / $402
= 16.6 years
(Note: We eliminate land and construction in progress from the numerator
because land is never depreciated and construction in progress represents
assets that are not in service yet and are, consequently, not yet depreciable).
The footnote indicates that buildings have estimated average useful lives of
25-29 years, machinery and equipment of 10 years, dies, etc of 7 years, and all
other of 5 years.
b. Percent used up
= Accumulated depreciation/ Depreciable asset cost
= $4,271 / ($6,992 - $83 - $245)
= 64.1%
Assuming that assets are replaced evenly as they are used up, we would
expect assets to be 50% “used up,” on average. Deere’s 64.1% is higher than
this average. The implication is that Deere will require higher capital
expenditures in the near future to replace aging assets.
P6-41 (45 minutes)
($ millions)
a. Dow uses LIFO inventory costing for 34% of inventories at December 31,
2007. As of 2007, the LIFO inventory reserve is $1,511 million. Thus,
cumulatively, pretax income has been reduced by $1,511 million
because Dow uses LIFO. Assuming a tax rate of 35%, Dow has saved
taxes of $528.9 million ($1,511 million × 35%), cumulatively. During 2007,
the LIFO reserve increased by $419 million ($1,511 million - $1,092
million), saving the company $146.65 million ($419 million × 35%) in
taxes. This tax saving increased operating cash flow by that same
amount.
b. The inventory turnover rate for 2007 is 7.17 (computed as
$46,400
).
$6,885  $6,058
2
The average inventory days outstanding for 2007 is 54.16 ($6,885 /
[$46,400/ 365 days]). DOW is a manufacturer, thus, it requires a certain
level of raw materials and continually maintains inventories in
production and awaiting delivery. The average inventory days
outstanding does not appear excessive.
We could usefully compare both of these ratios to those of other
manufacturers in the same industry as DOW to make a more informed
comparison.
c. Since the overall cost of its inventories has been increasing, DOW’s
reduction of inventory quantities resulted in the matching of lower-cost
inventories against higher current selling prices. This increased its
income by $321 million in 2007, $97 million in 2006, and $110 million in
2005. This reduction in inventory quantities is called LIFO liquidation.
P8-37 (40 minutes)
a. The current maturities of long-term debt are repayments of long-term
debt that must be made during the next year. Because they represent a
current obligation of the company, they are included among current
liabilities on the balance sheet. PBG chose to group its current
maturities of $7 million with its other short-term debt rather than report
them as a separate line in the current liabilities section of the balance
sheet. The latter is the usual custom.
Companies report maturities so that financial statement users can
assess future cash outflows. In particular, the $1,300 million of longterm debt scheduled to mature in 2009 must be repaid within two years
of the balance sheet date.
The $1,300 million amount is important to our analysis of the company’s
solvency. The company has two options in settling its debt: 1) refinance
the maturing debt with a new debt issuance, or 2) repay the debt from
cash flows in the year the debt matures. PBG generated $1,437 million of
cash from operating activities in 2007, the year that this debt footnote is
reported. A current maturity of $1,300 million would, therefore, require
the use of nearly all of this operating cash flow if PBG cannot refinance
the debt. Accordingly, the magnitude of this debt and its upcoming due
date should be viewed with some degree of concern.
b. There is an inverse relation between bond price and effective bond yield.
The information here reveals that the PBG bond maturing in 2029 is
selling at a discount (98.919% of par). This discount will cause the
effective yield to be more than the 7% coupon on this bond (7.06% in
this case). The market rates reflect underlying interest rates and risk
premia as of December 2008, whereas PBG established the coupon
rates when the bond was issued. Thus, assuming that the bonds were
originally issued at par, the discounted price that exists at December
2008 (98.919% of par) reflects the effect of increasing interest rates
and/or deteriorating credit position of PBG. Since the problem assumes
constant credit ratings, the discount must have resulted from an overall
increase in market interest rates since PBG issued the bond.
P8-37 (continued)
c. Lenders require bond covenants because lenders do not have voting
power like shareholders do. Lenders must, therefore, exercise their
control over the company via loan covenants. The covenants cited by
PBG relate to:
 the maximum proportion of debt in relation to equity capital
 the amount of debt in relation to earnings before interest, taxes and
depreciation (EBITDA)
 the level of secured debt as a percentage of total assets
 senior notes that limit certain managerial actions
By limiting the amount of debt that PBG can issue, lenders seek to
control the default risk. These covenants, while beneficial to lenders,
limit PBG’s flexibility, potentially to the detriment of shareholders.
d. Discounts arise when the market rate is higher than the coupon rate on
the date the bond is issued. Subsequent to issuance, PBG will amortize
the discounts to interest expense; that is, the reduction of the discount
increases PBG’s reported interest expense each period.
P8-38 (20 minutes)
a. CVS paid $468.2 million for interest in 2007. Its average long-term debt
during 2007, is $7,769.7 million [($10,481.9 million + $5,057.4 million) / 2].
Therefore, the average coupon rate is 6.03%, computed as $468.2 /
$7,769.7.
CVS recorded interest expense of $468.3 million in 2007. This yields as
average effective rate of 6.03%.
b. CVS reports coupon rates ranging from 4.00% (on $650 million) to 8.52%
(on $44.5 million). Thus, the average coupon rate of 6.03% seems
reasonable given the information disclosed in the long-term debt
footnote. One might also weight the given interest rates by the total loan
amounts to better estimate that rate.
P8-38 (concluded)
c. Interest paid can differ from interest expense if the bonds are sold at a
premium or at a discount. Interest expense is computed using the
effective interest rate method, which uses the debt’s net book value and
the effective (yield) interest rate (the market rate prevailing when the
bond was issued). CVS’s interest expense and interest paid are nearly
equal, which means that the company issued most of its debt at par.
d. The current maturities of long-term debt are repayments of long-term
debt that must be made during the next year. Because they represent a
current obligation of the company, they are included among current
liabilities on the balance sheet. Companies report maturities so that
financial statement users can assess future cash outflows. In particular,
the $1.8 billion of long-term debt scheduled to mature in 2010 must be
repaid within three years of the balance sheet date. The $1.8 billion
amount is important to our analysis of the company’s solvency. The
company has two options in settling its debt: 1) refinance the maturing
debt with a new debt issuance, or 2) repay the debt from cash flows in
the year the debt matures. CVS generated $ 3,229.7 million of cash from
operating activities in 2007, the year that this debt footnote is reported.
A current maturity of $1.8 billion would, therefore, require the use of
over half of this operating cash flow if CVS cannot refinance the debt.
Accordingly, the magnitude of this debt and its upcoming due date
should be viewed with some degree of concern.
e. There is an inverse relation between bond price and effective bond yield.
The information here reveals that the CVS bond maturing in 2017 is
selling at a discount (86.539% of par). This discount will cause the
effective yield to be more than the 5.75% coupon on this bond (7.96% in
this case). The market rates reflect underlying interest rates and risk
premia as of December 2008, whereas CVS established the coupon rates
when the bond was issued. Thus, assuming that the bonds were
originally issued at par, the discount that exists at December 2008
reflects the effect of increasing interest rates and/or deteriorating credit
position of CVS. Since the problem assumes constant credit ratings, the
discount must have resulted from an overall increase in market interest
rates since CVS issued the bond.