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Required Replace each of the italicized letters with the correct numerical value.

Interpreting the Stockholders’ Equity Section of the Balance Sheet
P9-17
Objs. 3, 4, 5 Hampton, Inc. began operations on January 1, 2005. On December 31, 2006, it reported the
following stockholders’ equity section of its balance sheet.


December 31, 2006 2005

Stockholders’ equity
7% cumulative preferred stock, $100 par value $ 300,000 $ 300,000
Common stock, $2 par value 150,000 120,000
Paid-in capital in excess of par value 830,000 620,000
Retained earnings 362,500 157,500
Treasury stock (16,800) (25,725)
Total stockholders’ equity $1,625,700 $1,171,775




The company has a policy of paying out 10% of its net income as cash dividends. The date of
declaration is always 30 days after the end of the year, and the date of payment occurs 60 days
after the end of the year. At year-end 2005, the average price of treasury stock was $10.50. At
year-end 2006, the average price of treasury stock was $12.

Required
A. How many preferred shares have been issued as of year-end 2005 and 2006?
B. How many common shares have been issued as of year-end 2005? As of year-end 2006?
C. How many treasury shares are there at year-end 2005? At year-end 2006?
D. How many common shares are outstanding at year-end 2005? At year-end 2006?
E. What was the average price (at original issuance) of common stock as of year-end
2005?
F. What was the average selling price of the shares issued during 2006?
G. What was net income for 2005? For 2006?
H. What was the dividend per share paid to preferred stock on March 1, 2006?
I. What was the dividend per share paid to common stock on March 1, 2006?
J. What is the dividend per share that is scheduled to be paid to common stock on March
1, 2007? Why?

Interpreting the Stockholders’ Equity Section of the Balance Sheet
P9-18
Objs. 3, 4, 5 Nakishima Industries reported the following stockholders’ equity section of its balance sheet
at December 31, 2005.

December 31, 2005 2004
Stockholders’ equity
8.5% cumulative preferred stock, $25 par value $ 450,000 $ 375,000
Common stock, $5 par value 680,000 575,000
Paid-in capital in excess of par value, common 4,050,000 2,500,000
Retained earnings 9,400,300 7,300,800
Treasury stock (1,970,050) (1,510,000)
Total stockholders’ equity $12,610,250 $ 9,240,800

The company has paid cash dividends annually for 24 years. There are no dividends in ar-
rears. The date of declaration is always March 1 and the amount of dividends declared is al-
F357
CHAPTER F9: Financing Activities
359
Financing Activities

ways 25% of prior year net income. Year 2004 net income was $2.0 million. At year-end 2005,
the average cost of treasury stock was $31 per share. At year-end 2004, the average price of
treasury stock was $25.

Required
A. How many preferred shares have been issued as of the end of 2005 and 2004?
B. How many common shares have been issued as of the end of 2005? As of year-end 2004?
C. How many treasury shares are there at year-end 2005 and at year-end 2004?
D. How many common shares are outstanding at year-end 2005 and at year-end 2004?
E. As of year-end 2005, what was the average price (at original issuance) of common stock?
F. What was the average selling price of the common shares issued during 2005?
G. What was net income for 2005?
H. What was the amount of the dividend per share paid to preferred stock during 2005?
I. What was the amount of the dividend per share paid to common stock during 2005?
(Assume there were 54,600 common shares outstanding at the date of the 2005 divi-
dend distribution.)
J. What is the dividend per share that is scheduled to be paid to common stock in 2006?
(Assume there will be no change in the number of shares outstanding between Decem-
ber 31, 2005 and the distribution of dividends in 2006.)

Determining Whether a Liability Exists
P9-19
Objs. 1, 2, 3, 4, 5 Determine if a liability should be recorded in each of the following cases involving the Soft-Wear
Manufacturing Company. If there is no liability, explain how the item should be recorded.
A. The company guarantees to repair or replace any of its products that are defective.
B. The company estimates that some customers will not pay for merchandise purchased
on credit.
C. The company obtains an asset and signs a lease that extends for one-third of the useful
life of the asset.
D. The company is being investigated for potential pollution problems by the Environ-
mental Protection Agency. The company’s engineers believe it is likely that the com-
pany will be held responsible for an expensive cleanup activity.
E. The company has issued bonds that are maturing at the end of the current month.
F. The company is being sued by an unhappy customer. The case has not yet come to
court.
G. The company has declared a 20% stock dividend.
H. The company has declared a $0.25 cash dividend to be paid on all outstanding shares.
I. The preferred stock is cumulative and dividends have not been paid for three years.
J. The company has a noncontrolling interest of 3%.
K. The company has bonds outstanding that are convertible into common stock. The
company’s accountants believe that bond holders are likely to convert their bonds be-
cause the company has performed exceptionally well this year.
L. Stock options have been issued to the company’s executives. The options have not yet
been exercised.

Excel in Action
P9-20
In March 2005, the Wermz’s decided to expand their business. They purchased an existing
chain of bookstores for a price of $5 million. They financed their purchase by issuing $3 mil-
lion of common stock and by issuing $2 million of 20-year bonds payable. Interest will be
paid monthly beginning in April 2005. The stated rate of interest on the bonds is 9% (annual
interest payments are 9% of $2 million). The bonds were sold to earn a 9.25% interest rate
(the actual annual rate of interest is 9.25%).
SPREADSHEET

Required Use a spreadsheet to determine the present value of the bonds. Enter the captions
(as shown in the example on the next page) in cells A1 to A7.
In cell B1, enter the maturity value of the bonds.
In cell B2, calculate the amount of interest paid each month.
In cell B3, calculate the actual monthly interest rate.
(Continued)
F358 FinancingSECTION F2: Analysis and Interpretation of Financial Accounting Information
360 Activities

In cell B4, calculate the number of months during which interest will be paid.
In cell B5, calculate the present value of the interest payments. Use the PV function (click
on the Function button and select Financial and PV). Enter the rate (B3), number of periods
(B4), and monthly payments (B2). The resulting value is negative because it is a cash outflow.
Change the amount to a positive value by multiplying by ( 1).
In cell B6, calculate the present value of the maturity value of the bonds. The calculation
is based on the equation PV MV/(1 R)t, where PV is present value, MV is maturity value
(B1), R is the actual interest rate (B3), and t is the number of periods until maturity (B4).
In cell B7, calculate the total maturity value of the bonds.




Beginning in cell A9, prepare an amortization table for April through December 2005 for
the bonds. Use Exhibit 3 in this chapter as an example. Use formulas for all spreadsheet cal-
culations. (See the Continuous Problem in Chapter F8 if you need help.) How much interest
expense will The Book Wermz incur on the bonds in 2005? How much interest will the com-
pany pay? How much liability will the company report for the bonds at the end of 2005?
Suppose the effective interest rate was 8.75%. What would be the present value of the
bonds? How much interest expense would the company incur in 2005?
Suppose the effective interest rate was 9.0%. What would be the present value of the
bonds? How much interest expense would the company incur in 2005?


Multiple-Choice Overview of the Chapter
P9-21
1. Which of the following are attributes of a liability?

Result from a Involve a Promise to Convey
Prior Transaction Resources in the Future
a. Yes Yes
b. Yes No
c. No Yes
d. No No

2. Which of the following should be reported on a year-end balance sheet under the
heading of short-term debt?

Wages Already Earned by 30-Year Debentures That Have
Employees but Not Yet Paid Been Outstanding for 29 Years
a. Yes Yes
b. Yes No
c. No Yes
d. No No

3. A contingency is reported on the balance sheet as a liability if
a. it arises from a potential claim regarding damage to the environment.
b. a loss is probable and it can be reasonably estimated.
c. a lawsuit has been filed.
d. it involves a potential loss of a large amount of money.

4. The stockholders’ equity section of Tarro Company’s balance sheet includes the follow-
ing selected information.
F359
CHAPTER F9: Financing Activities
361
Financing Activities

Common stock, $1 par, 15,000 shares authorized,
9,000 shares issued, 7,000 shares outstanding $ 27,000
Additional paid-in capital in excess of par value 14,000
Retained earnings (20,000)
Treasury stock

What is the correct balance of the common stock account?
a. $15,000
b. $11,000
c. $9,000
d. $7,000

5. A stockholder who owns 5% of the common stock of a corporation has a right to each
of the following except
a. 5% of any dividends paid to common stockholders.
b. to cast votes on matters brought to stockholders for a vote.
c. to receive a dividend of 5% of net income for the current period.
d. to purchase 5% of any additional common stock issued by the company.

6. A corporation had retained earnings of $400,000 at December 31, 2004. Net income for
2005 was $175,000, and the company paid a cash dividend of $75,000. Also, the com-
pany repurchased shares of its stock during the year at a total cost of $50,000. The bal-
ance of retained earnings at December 31, 2005, would be
a. $450,000.
b. $550,000.
c. $575,000.
d. $500,000.

7. A corporation issued a 10% stock dividend during its 2005 fiscal year. The market
value of the stock was $20 per share at the time the dividend was issued. One million
shares of stock were outstanding. The par value of the stock was $1 per share. Which
of the following correctly identifies the effect on the financial statements of this trans-
action?
Assets Equity Net Income
a. Increase Decrease No effect
b. No effect Decrease No effect
c. No effect No effect No effect
d. No effect Decrease Decrease
8. Which of the following is not a true statement about preferred stock?
a. Preferred stockholders receive a current cash dividend before common stockhold-
ers do.
b. Preferred stockholders receive a stated dividend each year.
c. Preferred stock generally does not have voting privileges.
d. The cumulative feature serves to protect preferred stockholder interests.

9. The statement that “dividends are not an expense” is
a. always true.
b. never true.
c. sometimes true.
d. frequently true.

10. The presence of a foreign currency adjustment on the balance sheet means that
a. the company owns at least one foreign subsidiary.
b. the company’s primary operations are located in a foreign country.
c. shares of the company’s stock have been sold to foreign investors.
d. retained earnings of a foreign subsidiary have been appropriated.
F360 FinancingSECTION F2: Analysis and Interpretation of Financial Accounting Information
362 Activities


Projects
CASES
Making Credit Decisions
C9-1
Objs. 1, 2, 3, 4 Suppose that you are an employee of the loan department of Metropolitan Bank, and one of
your primary tasks is analyzing information provided by organizations applying for commer-
cial loans. Most applicants are small businesses seeking additional capital to acquire long-term
assets. Other applicants are seeking financing to acquire existing businesses. A typical appli-
cant is Cleopatra Jones, who owns Cleopatra’s, a women’s clothing store. Ms. Jones has ap-
plied for a loan of $50,000 to finance an expansion of her business.

Required Identify the types of information you would need from Ms. Jones to help you
make a loan decision. Explain why each type of information would be useful.


Interpreting Stockholders’ Equity
C9-2
Objs. 3, 4, 5 Selected disclosures from a consolidated balance sheet are shown below.



December 31, 2004 2003

(in millions)
Total assets $3,759.7 $3,774.4
Total liabilities $2,411.9 $2,652.3
Stockholders’ equity:
Preferred stock 785.1 789.0
Common stock, shares issued:
2004 171.2; 2003 162.6 0.9 0.8
Retained earnings (accumulated deficit) 79.9 (114.0)
Other capital 481.9 446.3
Total stockholders’ equity $1,347.8 $1,122.1
Total liabilities and stockholders’ equity $3,759.7 $3,774.4




A note to the financial statements reveals:
The Company has 180,000,000 authorized shares of common stock. In February of
2002, the Certificate of Incorporation of the Company was amended to change the par
value of the common stock from $4 per share to $0.01 per share.
In 2003, the Company resumed payment of dividends on preferred stock, which
had been suspended in February 2002. Preferred dividends of $53.9 million and
$61.4 million were in arrears at December 31, 2004 and December 31, 2003, respec-
tively.

Required Prepare a report that explains the following:
A. Of what economic significance is the par value of a company’s stock? What is the sig-
nificance of the decision to restate the par value of the stock? What is the advantage for
the company?
B. What are the primary attributes of preferred stock? In what ways is preferred stock eq-
uity? In what ways is it debt? Why do companies issue preferred stock?
C. What effect does the suspension of dividends on the preferred stock have on the finan-
cial statements? What economic effect does it have on the company? If the preferred
stock and dividends in arrears were reported as liabilities, what would be the effect on
the company’s balance sheet?
D. Assess the position of the company’s common stockholders at the end of 2004.
F361
CHAPTER F9: Financing Activities
363
Financing Activities

Analyzing Liabilities and Stockholders’ Equity
C9-3
Objs. 1, 2, 3, 4, 5 Review the financial statements of General Mills, Inc., provided in Appendix B of this book.

Required Write a report that covers the following:
A. How important were liabilities as a source of financing for assets as of the end of fiscal
2002? What are some of the implications of this? Discuss.
B. What were the company’s most significant liabilities at year-end 2002? Did the relative
significance of certain liabilities change from the prior year? Describe any material
changes.
C. Did financing activities concerning liabilities affect cash flows during 2002? Did financ-
ing activities concerning liabilities affect its net income in 2002? Identify any such af-
fects.
D. Describe any significant changes in the stockholders’ equity section of the balance sheet
that occurred between year-end 2001 and year-end 2002. For any significant changes,
indicate what caused them to change.
F10 10
ANALYSIS OF FINANCING
ACTIVITIES
How do we finance our business?

C hapter 9 discussed financing activities, including accounting for debt and equity.
Accounting involves more than determining amounts to report in financial state-
ments. It involves the analysis of information about business activities to understand
those activities and how they affect the performance and value of a business.

If Maria and Stan are going to increase the size of their business, they will need additional
financing. They need to be aware of the effect that debt and equity have on a business’s prof-
itability and value. And they need to make financing decisions that increase company value and
permit it to survive for the long run.

Maria, the company president, Stan, the vice president of operations, and Ellen, the vice presi-
dent of finance of Mom’s Cookie Company, sat in Maria’s office discussing financial plans for
their company. Maria and Stan formed the company to sell cookies produced from their mom’s
recipes. Initially, the company purchased its products from bakeries because it did not have suf-
ficient financial resources to buy the equipment and facilities it would need to manufacture its
own products. As the company’s products have become more popular, Maria and Stan have de-
cided to expand their company. The volume of sales is sufficient to warrant acquiring production
facilities. Ellen was hired recently as vice president of finance to help the company with its growth
potential. They have met to discuss how to finance their company’s expansion.


FOOD FOR THOUGHT
What issues should managers consider when deciding on the amounts of debt and equity financing to use
in a company? How should investors analyze a company’s financial statements to assess managers’
financing decisions and the effects of these decisions on profits and company value?


I’ve noticed that different companies use different amounts of debt and equity financing. How can we
Maria:
determine the right amounts for our company?
Ellen: One issue we can look at is the effect that different forms of financing can have on the risk and return of
owners and other stakeholders.
Stan: Can it really make that much of a difference?
Ellen: Yes. Many companies have a hard time surviving because they made financing decisions that were not
right for the companies. There are good reasons that some companies use more debt than others. Let’s
take a look at some of these reasons.
F363
CHAPTER F10: Analysis of Financing Activities
366 Analysis of Financing Activities


OBJECTIVES

Once you have completed this chapter, you 4 Use financial statements to evaluate the
should be able to: financing activities of different companies.
1 Define capital structure, and explain why it 5 Determine and explain the effect of
is important to a company. financial leverage on a company’s risk and
return.
2 Explain when it is beneficial for a company
to use financial leverage. 6 Use cash flow and liquidity measures to
evaluate financing decisions.
3 Explain why cash flows are important for a
company’s financing decisions. 7 Explain why financing activities are
important for determining company value.




FINANCING DECISIONS
Maria, Stan, and Ellen know that if the company is properly managed, it will have a
good chance of making a lot of money. They also knew of several companies like theirs,
with promising futures, that failed within a few years because of poor financial man-
agement. They are determined not to make the same mistakes. Let’s follow their con-
versation as they discuss their financing alternatives.
Stan continued the conversation. “The potential for our product is good. At our
current growth rate, we should sell $3 million of product next year, and I believe sales
will grow at a rate of 20% per year for the foreseeable future. We need $5 million to
fund production facilities and to expand production and marketing activities. Of this
amount, $4 million will go into plant assets.”


Capital Structure Decisions
Maria spoke next, “OK, we know we have great potential. We have a quality product
OBJECTIVE 1
that meets the needs of a large market. Our current concern is how do we finance our
Define capital structure, production costs? I think we might want to use as much debt as possible. A friend of
and explain why it is mine from college is a manager with a company that uses well over 50% debt in its cap-
important to a company. ital structure, and the company has been very successful. What do you think?”
Stan interrupted, “What do you mean by capital structure?”
“Capital structure is the relative amounts of debt and equity used by a company
to finance its assets,” Ellen answered. “Those are our basic choices. Either we can bor-
row money, or we can issue stock. Some companies are successful using a lot of debt,
but our situation is different. I think we should rely primarily on equity.”
“I don’t understand,” Stan replied. “What difference does it make? We need $5 mil-
lion. As long as we get it from someone, why should we care where it comes from? A
dollar of debt will pay for just as many assets as a dollar of equity.”
“Yes,” answered Ellen, “but that’s not the complete story. Let’s look at some num-
bers. Exhibit 1 contains projected sales and operating income figures for the next three


Exhibit 1 (In thousands) Year 1 Year 2 Year 3
Projected Sales and
Sales $ 3,000 $ 3,600 $ 4,320
Income for Mom’s
Cost of goods sold (1,800) (2,160) (2,592)
Cookie Company
Operating expenses (1,000) (1,000) (1,000)
Operating income 200 440 728
Income taxes (60) (132) (218)
Net income $ 140 $ 308 $ 510
F364 SECTION F2: Analysis and Interpretation of Financial Accounting Information
367
Analysis of Financing Activities

years based on Stan’s estimates. Operating costs will be high relative to sales next year
because of initial training and development costs and special marketing efforts to in-
crease customer awareness of our product. Also, we will not be producing at full capac-
ity until we get more of our product into customers’ hands and they see how good it is.”
“I still don’t see the point,” Stan observed.
Ellen responded, “Well, let’s see what happens to our profits and stockholder re-
turns depending on how we finance our operations. Exhibit 2 provides a simplified bal-
ance sheet for Mom’s Cookie Company, assuming that we finance our company without
any long-term debt. These numbers assume that we invest $4 million in plant assets
and start with $1 million in current assets. Further, I assume that current assets will in-
crease at the same rate as sales, 20% per year. Plant assets will be replaced each year as
they wear out to maintain a constant investment, at least for the first few years. Also, I
assume that we issue $4.2 million of stock and use current liabilities to fund the re-
mainder of our assets. Some of our current assets, such as inventories, can be purchased
on short-term credit from suppliers. Therefore, Accounts Payable and other current li-
abilities will provide a source of funding for a portion of current assets.


Exhibit 2 (In thousands) Year 1 Year 2 Year 3
Projected Summary
Assets:
Balance Sheet for
Current assets $1,000 $1,200 $1,440
Mom’s Cookie Company
Plant assets 4,000 4,000 4,000
Total assets $5,000 $5,200 $5,440
Liabilities:
Current liabilities $ 800 $ 960 $1,152
Long-term debt 0 0 0
Total liabilities 800 960 1,152
Stockholders’ equity 4,200 4,240 4,288
Total liabilities and equity $5,000 $5,200 $5,440




“Using this financing arrangement,” Ellen continued, “our income statement will
look like Exhibit 1, which does not include any interest expense. A useful measure of
performance, in addition to net income, is return on equity. Return on equity (ROE)
is net income divided by stockholders’ equity. It measures net income relative to the
amount invested by stockholders in a company, including retained earnings. Investors
and financial analysts use return on equity to compare the performances of companies,
either to compare one company with another or to compare a company’s performance
in one period with its performance in another period. From the data in Exhibits 1 and
2, we can compute Mom’s Cookie Company’s return on equity as shown in Exhibit 3.


Exhibit 3 (In thousands) Year 1 Year 2 Year 3
Return on Equity (Net
Net income $ 140 $ 308 $ 510
Income Stockholders’
Stockholders’ equity $4,200 $4,240 $4,288
Equity) for Mom’s
Return on equity 3.3% 7.3% 11.9%
Cookie Company




“Exhibit 3 indicates that stockholders will earn 3.3 cents next year for each dollar
they invest in Mom’s Cookie Company,” Ellen observed. “Three years from now, they
will earn 11.9 cents for each dollar invested. Now let’s see what happens if we include
long-term debt in our capital structure.”
F365
CHAPTER F10: Analysis of Financing Activities
368 Analysis of Financing Activities

The Effect of Financial Leverage
“Let’s look at the numbers,” Ellen continued. “Exhibit 4 describes the results if we use
OBJECTIVE 2
$2.5 million of liabilities and $2.5 million of equity next year. This would give us an
Explain when it is initial debt-to-equity ratio of 1.0 ($2.5 million of liabilities $2.5 million of equity)
beneficial for a company and a debt-to-assets ratio of 0.5 or 50% ($2.5 million of liabilities $5 million of as-
to use financial leverage. sets). These ratios are used frequently as measures of capital structure; the higher the
ratios, the more debt in a company’s capital structure. It’s not uncommon for some
companies to have a debt-to-assets ratio of 70% or more, as you noted earlier, Maria.
But in our case I think it is unwise.
“As you can see in Exhibit 4,” Ellen continued, “net income would be lower each
year because of interest expense on the long-term debt. I have assumed a 10% interest
rate, which is about what debt would cost us. Our rate would be higher than that for
established companies because of the risk associated with an unproven company like
ours. Also, I have assumed that we will maintain a debt-to-equity ratio of 1.0 each year.


Exhibit 4 (In thousands) Year 1 Year 2 Year 3
Projected Financial
Sales $ 3,000 $ 3,600 $ 4,320
Results for Mom’s
Cost of goods sold (1,800) (2,160) (2,592)
Cookie Company Based
Operating expenses (1,000) (1,000) (1,000)
on a 1.0 Debt-to-Equity
Operating income 200 440 728
Ratio
Interest expense (170) (164) (157)
Pretax income 30 276 571
Income taxes (9) (83) (171)
Net income $ 21 $ 193 $ 400
Assets:
Current assets $ 1,000 $ 1,200 $ 1,440
Plant assets 4,000 4,000 4,000
Total assets $ 5,000 $ 5,200 $ 5,440
Liabilities:
Current liabilities $ 800 $ 960 $ 1,152
Long-term debt 1,700 1,640 1,568
Total liabilities 2,500 2,600 2,720
Stockholders’ equity 2,500 2,600 2,720
Total liabilities and equity $ 5,000 $ 5,200 $ 5,440
Return on equity 0.8% 7.4% 14.7%




“While net income is lower each year, stockholders’ equity also is lower, primarily
because we will not need to issue as much stock to finance the company. Observe from
Exhibit 4, however, that return on equity is lower in the first year if we use debt. In the
second year, return on equity is about the same whether we use debt or not (compare
with Exhibit 3). In the third year, as profits increase, return on equity is higher if we
use debt than if we use only equity.
“Exhibit 5 provides a graph that helps explain the effect of using debt. The graph
shows the amount of return on equity Mom’s Cookie Company would report at vari-
ous levels of sales revenues. Return on equity varies more when larger amounts of debt
are used.”
“This effect is known as financial leverage,” Maria remarked. Financial leverage
(FL) is the use of debt to increase a company’s return on equity. The more debt there
is in a company’s capital structure, the greater the financial leverage. As you can see
from the graph, financial leverage magnifies return on equity. When return on equity
is low, financial leverage makes it lower. When return on equity is high, financial lever-
age makes it higher.
F366 SECTION F2: Analysis and Interpretation of Financial Accounting Information
369
Analysis of Financing Activities

Exhibit 5 16.0%
The Effect of Financial High Financial Leverage
14.0%
Leverage on Return on
Low Financial Leverage
Equity 12.0%




Return on Equity
10.0%
8.0%

6.0%

4.0%

2.0%

0.0%
$3,000 $3,500 $4,000
Revenues



“The magnification effect of financial leverage can be thought of as a simple formula:

Return on Equity (ROE) Return on Assets (ROA) Financial Leverage (FL)
Net Income Net Income Total Assets
Stockholders’ Equity Total Assets Stockholders’ Equity

As explained earlier in this chapter, net income divided by stockholders’ equity is re-
turn on equity. Recall from Chapter 2 that net income divided by total assets is known
as return on assets (ROA). The formula for calculating financial leverage (FL) is total
assets divided by stockholders’ equity. If a company has a lot of debt, the ratio of to-
tal assets to stockholders’ equity will be large.
“You can see the effect of leverage by looking at Mom’s Cookie Company’s num-
bers. In the first year, if we don’t use any long-term debt, the formula would look like
this:

ROE ROA FL
$140 $140 $5,000
$4,200 $5,000 $4,200
3.3% 2.8% 1.19

The only leverage we would have would come from current liabilities.
“If we use $2.5 million of liabilities, the formula would show this:

ROE ROA FL
$21 $21 $5,000
$2,500 $5,000 $2,500
0.8% 0.4% 2.0

“If we don’t use any long-term debt, the magnification factor is about 1.2. If we
use long-term debt, the magnification factor is 2.0. Though higher financial leverage
works against us when our profits are low, it works for us in later years when we start
making more profit.”
“That’s why I thought we should use a relatively large amount of debt,” Maria con-
tinued. “We expect Mom’s Cookie Company to earn a lot of money in the next few
years. If we use a lot of debt, we can leverage those earnings to generate a high return
on equity. This will make our company more valuable and probably will make us rich.
Ellen’s graph in Exhibit 5 demonstrates what will happen. In the third year, return on
F367
CHAPTER F10: Analysis of Financing Activities
370 Analysis of Financing Activities

equity will be about 15% if we use long-term debt, but it will be only about 12% if we
don’t. I don’t see why you want to avoid debt, Ellen.”
Ellen replied, “If we could be sure of the numbers in Stan’s estimates, I would agree
that financial leverage would make Mom’s Cookie Company more valuable. However,
you have to remember that these numbers are only estimates, and that we are dealing
with a relatively unknown product in a highly competitive market. Suppose we don’t
start out with sales of $3 million, and suppose sales don’t grow at 20% per year. That
financial leverage magnification factor will continue to work against us as long as our
profits are low. We need to examine some other factors, as well. Let’s take a break and
continue our discussion later.”




1 SELF-STUDY PROBLEM Financial statement information is presented below for Androm-
eda Corporation, which manufactures airline-tracking equip-
ment. Andromeda is considering a change in its capital structure. Management has
proposed issuing $200 million of additional long-term debt. The long-term debt would
be used to repurchase a portion of the company’s common stock. This purchase would
reduce the company’s stockholders’ equity by $200 million. The interest expense on the
additional debt would be $14 million. The company’s tax rate is 35% of pretax income.


(In millions) 2004

Sales $982
Cost of goods sold 607
Operating expenses 294
Operating income 81
Interest expense (6)
Pretax income 75
Income taxes (26)
Net income $ 49
Assets:
Current assets $277
Plant assets 555
Total assets $832
Liabilities:
Current liabilities $212
Long-term debt 75
Total liabilities 287
Stockholders’ equity 545
Total liabilities and equity $832




Required
A. Compute Andromeda’s return on equity for 2004 as reported.
B. Compute what Andromeda’s return on equity would have been in 2004 if the
company had issued the additional debt and had repurchased common stock.
You will need to recompute net income beginning with operating income. Also,
recompute liabilities and equity on the balance sheet. Round to the nearest mil-
lion dollars.
C. Based on these computations, would the change in capital structure be good for
Andromeda’s stockholders?
The solution to Self-Study Problem 1 appears at the end of the chapter.
F368 SECTION F2: Analysis and Interpretation of Financial Accounting Information
371
Analysis of Financing Activities


EFFECTS FINANCING DECISIONS CASH FLOW LIQUIDITY
OF ON AND
Ellen continued the discussion after the break. “Also, consider our cash flows. We will
OBJECTIVE 3
have a lot of cash outflows next year to increase the size of the business. We will have
Explain why cash flows to extend credit to some of our customers just to compete in this market. Consequently,
are important for a some of our sales may not be collected for several months. At the same time, we will
company’s financing be paying for materials and labor to create our products.
decisions. “If we add interest payments to our cash demands, we could face cash flow prob-
lems, especially if sales are less than expected. If sales are lower than we anticipate, we
can cut back on materials purchases and reduce labor costs, but we can’t skip interest
payments. If we can’t make those payments and still have enough money to meet our
normal operating needs, we’ll be in serious trouble before we give our company time
to prove itself. If we get into cash flow problems because of too much debt, we’ll have
trouble staying in business. We will have difficulty borrowing additional money because
creditors already will be concerned about getting repaid for the original loan. We won’t
be in a good position to sell additional stock, either. Who will want to buy stock in a
company that can’t pay its debts?
“No, Maria, I really think our situation is too risky to use much debt. Our sales
may be lower than expected, and our profits may be more volatile than we anticipate.
Until we get the business on solid ground and know more about our market, I think
we should stick with equity financing. At some time in the future, once we are more
established and can be pretty sure of our profits and cash flows, we might consider us-
ing more financial leverage.”


Dividend Decisions
Maria and Stan still were not completely satisfied. “What about dividends?” Stan asked.
“I understand what you are saying about interest, but won’t we have to pay dividends
on the stock we sell? Investors aren’t going to give us their money without expecting
something in return. If we pay dividends, we’ll be facing the same cash flow problems
we would if we use debt.”
“I don’t think so,” Ellen responded. “People who invest in new companies like ours
know the risk they are taking. They invest for long-run profits and stock value, not for
short-run dividends. If we convince the market of our growth potential and demonstrate
good growth in the first few years, we will create good value for our stockholders.
“Dividend policy is an important financing decision for a company. Managers must
decide how much cash dividend to pay each fiscal period. Dividend policies vary con-
siderably among companies. Some companies, especially new ones like ours with good
growth potential, do not pay dividends.
“Stockholders benefit from their investments in two ways. One way is by receiving
dividends. The other way is by having the value of their stock increase over time. Mom’s
Cookie Company has great growth potential. If we invest the cash from our operating
activities back in the company to create greater production and sales capacity and earn
higher profits, our investors will be better off than if we pay dividends. If we can in-
crease sales by 20% each year, the value of our stock is likely to climb at a much higher
rate than if we pay cash dividends and grow more slowly because we don’t have enough
cash to invest. Exhibit 6 illustrates the dividends relative to investment of cash.
“Stockholders realize the value of growth. Many growth companies don’t pay div-
idends or pay only low dividends. Companies like Microsoft and Intel have paid very
few dividends, but they have made millions for their investors because of higher stock
values. Of course, we have to deliver growth, not just promise it. If we don’t pay divi-
dends because we aren’t creating enough profits and cash flows to make these payments,
we’ll be in trouble. But we would be in more trouble if we had a lot of interest to pay.
Interest would decrease our profits and cash flows, compounding our problems. If we
can’t become profitable and grow at a reasonable rate, we won’t be in business long,
regardless of how we finance Mom’s Cookie Company.
F369
CHAPTER F10: Analysis of Financing Activities
372 Analysis of Financing Activities

Exhibit 6 Paid to
Stockholders Benefit Investors
from Dividends and from
Dividends Investor
Investment of Cash in
Benefits
Productive Assets


Cash


Retained
and Invested Productive Increased Greater
Assets Profits Stock Value




“Thus, dividends are not a concern. Stockholders won’t expect them initially and
will be satisfied as long as the price of their stock increases each year consistent with
their expectations. Mom’s Cookie Company will be a less risky company if we avoid
much debt. Keep in mind that investors expect a higher return from a high-risk com-
pany than from a low-risk company. We are already a high-risk company because we
are new and we are operating in a highly competitive market. Financial leverage would
increase this risk even more and might scare away many investors. At a minimum, it
would reduce the amount we will receive from selling stock. If we increase our risk, in-
vestors will bid the price of our stock down because they will be more uncertain about
our ability to survive and generate future profits.”


Other Financing Alternatives
“What about other alternatives?” Stan queried. “We could lease some of our plant as-
sets. Wouldn’t that be an alternative to equity financing?”
“Yes,” Maria added, “and what about preferred stock? Could we use that rather
than common stock for some of our financing needs?”
Ellen responded, “Leases wouldn’t improve our situation very much. We would
still have to make payments each period. Most of the leases would be long-term capi-
tal leases that are equivalent to debt. We would be making interest and principal pay-
ments just the way we would be paying other creditors. Leases would add to our risk
and liquidity problems just like other forms of debt.
“We would also need to be careful with preferred stock. If we sell preferred, we
probably will have to make dividend payments to the preferred stockholders. Also, our
common stock will be a bit riskier because of the dividend and liquidation preferences
of the preferred stock. If we are not as successful as we hope to be in the first few years,
common stockholders stand to lose more money if we issue preferred stock than if we
don’t. If we can sell enough common stock to meet our financing needs and can get a
reasonable price for our stock, I would not issue preferred stock. Let’s use preferred
stock as an alternative only if we can’t meet all of our needs by issuing common.”
Maria and Stan left the meeting feeling comfortable with Ellen’s explanations. They
had high expectations for their product, and they had faith in Ellen’s understanding of
financing activities.


INTERPRETATION FINANCING ACTIVITIES
OF
The first part of this chapter examined the financing decisions of managers and the ef-
fects of these decisions on a company’s financial statements. This section examines fi-
nancial statement information provided by actual corporations. We use this information
to demonstrate how investors and other decision makers can interpret the financing
F370 SECTION F2: Analysis and Interpretation of Financial Accounting Information
373
Analysis of Financing Activities

activities of companies and make decisions about companies’ risk, return, and value at-
OBJECTIVE 4
tributes.
Use financial statements In this section, we will use a five-step process to analyze accounting information
to evaluate the financing for the purpose of evaluating financing activities.
activities of different
1. Identify financing activities for one or more companies and fiscal periods.
companies.
2. Measure capital structure for the companies and periods.
3. Evaluate the effect of the companies’ financing decisions on risk and return.
4. Evaluate the effect of financing decisions on cash flows and determine the ability
of companies to make debt and interest payments.
5. Examine the relationship between a company’s financing decisions and its value to
stockholders.
Exhibit 7 provides selected financial statement information for Krispy Kreme
Doughnuts, Inc. and Starbucks Corporation. Both companies produce and sell food
products. Therefore, they are comparable with respect to many activities.


A General Overview
Our analysis begins with a general overview of the two companies. In Exhibit 7, it ap-
pears that Starbucks is more profitable than Krispy Kreme. Net income for both com-
panies is positive in both years. However, Starbucks’ net income is considerably higher
than Krispy Kreme’s.
When comparing different companies, one must keep in mind that the sizes of the
companies usually are different. For that reason, ratios are used to make the financial
statement numbers comparable. For example, observe that Starbucks was more than
10 times larger than Krispy Kreme, based on the assets reported by each company. Ac-
cordingly, we should expect Starbucks’ net income to be larger than Krispy Kreme’s.


Exhibit 7 Selected Income Statement and Balance Sheet Information for Krispy Kreme and Starbucks

Krispy Kreme Starbucks
(In thousands) 2001 2000 2001 2000

Total revenues $ 300,715 $ 220,243 $ 2,648,980 $ 2,177,614
Operating expenses (250,690) (190,003) (2,052,969) (1,745,228)
General and administrative expenses (20,061) (14,856) (151,416) (89,902)
Depreciation and amortization expenses (6,457) (4,546) (163,501) (130,232)
Income from operations 23,507 10,838 281,094 212,252
Interest income (expense) 276 (1,232) 7,828 (51,682)
Income before income taxes 23,783 9,606 288,922 160,570
Provision for income taxes (9,058) (3,650) (107,712) (66,006)
Net income $ 14,725 $ 5,956 $ 181,210 $ 94,564
Assets:
Total current assets $ 67,611 $ 41,038 $ 593,925 $ 458,234
Long-term assets 103,882 63,920 1,257,114 1,033,312
Total assets $ 171,493 $ 104,958 $ 1,851,039 $ 1,491,546
Liabilities and Equity:
Total current liabilities $ 38,168 $ 29,586 $ 445,264 $ 311,666
Total long-term liabilities 7,646 27,617 29,848 31,481
Total liabilities 45,814 57,203 475,112 343,147
Shareholders’ Equity:
Common stock 85,060 15,475 791,622 750,872
Retained earnings 42,547 34,827 589,713 408,503
Other (1,928) (2,547) (5,408) (10,976)
Total shareholders’ equity 125,679 47,755 1,375,927 1,148,399
Total liabilities and shareholders’ equity $ 171,493 $ 104,958 $ 1,851,039 $ 1,491,546
F371
CHAPTER F10: Analysis of Financing Activities
374 Analysis of Financing Activities

A common method for comparing the income of different companies is to com-
pute return on assets, the ratio of net income to total assets. In 2001, Krispy Kreme’s
return on assets was 8.6% ($14,725 $171,493), compared with Starbucks’ return on
assets of 9.8% ($181,210 $1,851,039). In 2000, Krispy Kreme’s return on assets was
5.7% ($5,956 $104,958), compared with Starbucks’ 6.3% ($94,564 $1,491,546).
Both companies were more profitable in 2001 than in 2000. However, Starbucks was
more profitable in both years than Krispy Kreme.


Comparing Capital Structures
As a second step in our analysis of financing activities, we compare the capital struc-
tures of the two companies. We use ratios such as debt to assets and assets to equity
for this purpose. These measures compare the amount of debt (debt to assets) or eq-
uity (assets to equity) a company uses to finance its assets with the company’s total in-
vestment in assets. A high debt-to-assets ratio or a high assets-to-equity ratio indicates
that a company is using a lot of debt in its capital structure.
We include all liabilities as part of debt. For 2001,
Krispy Kreme’s debt-to-assets ratio was 26.7%
LEARNING NOTE
($45,814 $171,493), approximately equal to Star-
Many ratios do not have standard definitions. Various decision
bucks’ debt-to-assets ratio of 25.7% ($475,112
makers and companies compute ratios differently. For example,
$1,851,039). In 2000, Krispy Kreme’s debt-to-assets
debt to assets may include all liabilities in the numerator, or it
ratio was much larger at 54.5% ($57,203
may include only long-term debt. The denominator may use as-
$104,958).
sets from the beginning of the year, from the end of the year, or
Another measure of capital structure useful for
an average for the year. Therefore, be careful in comparing com-
comparing the effects of financing activities is finan-
panies. Make sure you understand how ratios were computed
cial leverage: the ratio of assets to stockholders’ eq-
and make sure the ratios were computed the same way for each
uity. For 2001, this ratio was 1.36 ($171,493
company.
$125,679) for Krispy Kreme and 1.35 ($1,851,039
$1,375,927) for Starbucks. Though this ratio uses a
different scale from the one used for the debt-to-assets ratio, it provides the same type
of information. These ratios indicate that Krispy Kreme and Starbucks used about
the same amount of debt in their capital structures in 2001. In 2000, Krispy Kreme’s
financial leverage of 2.20 ($104,958 $47,755) was much larger than Starbucks’ fi-
nancial leverage of 1.30 ($1,491,546 $1,148,399). Note that a company that uses more
debt in its capital structure has a higher debt-to-assets or assets-to-equity ratio than one
that uses less debt.



THE EFFECT FINANCIAL LEVERAGE RISK RETURN
OF ON AND
A third step in our analysis is to determine the effect of financial leverage on the risk
OBJECTIVE 5
and return of our companies. A ratio commonly used for this purpose is return on eq-
Determine and explain uity: net income divided by stockholders’ equity. This ratio is affected by a company’s
the effect of financial capital structure. The use of financial leverage (higher amounts of debt) magnifies a
leverage on a company’s company’s return on assets.
risk and return.
Return on Equity Return on Assets Financial Leverage
Net Income Net Income Total Assets
Stockholders’ Equity Total Assets Stockholders’ Equity

For example, Krispy Kreme’s return on equity in 2001 was 11.7% ($14,725 $125,679).
This amount is equal to Krispy Kreme’s return on assets times its asset to equity ratio:
11.7% 8.6% 1.36. Krispy Kreme’s financial leverage resulted in a return on equity
that was larger than its return on assets. What do these numbers mean in practical
terms? Think of them this way: If Krispy Kreme had financed its assets using equity
without any liabilities, its stockholders would have made 8.6 cents for each dollar they
invested in Krispy Kreme, including reinvested profits, in 2001. But, because Krispy
F372 SECTION F2: Analysis and Interpretation of Financial Accounting Information
375
Analysis of Financing Activities

Kreme used debt in its capital structure, its stockholders made 11.7 cents for each dol-
lar invested.
In 2000, Krispy Kreme’s return on equity was 12.5% ($5,956 $47,755) and was
higher than return on assets (5.7%) because of financial leverage: 12.5% 5.7%
2.20. Again, you can think of these numbers in practical terms by saying that stock-
holders earned 12.5 cents in 2000 for each dollar invested. If Krispy Kreme had not
used debt in its capital structure, its stockholders would have earned 5.7 cents for each
dollar invested. Thus, financial leverage works for stockholders when a company per-
forms well.
Financial leverage also worked for Starbucks’ stockholders because the company
was profitable in both years. Return on equity was 13.2% ($181,210 $1,375,927) in
2001 and 8.2% ($94,564 $1,148,399) in 2000. In each year, return on equity was
greater than return on assets because of financial leverage.
Observe that Krispy Kreme’s return on equity went down from 2000 to 2001, even
though its net income more than doubled. The decrease in return on equity was the
result of the change in financial leverage, which decreased from 2.20 to 1.36. Because
it used less debt and more equity in its capital structure in 2001 than in 2000, Krispy
Kreme earned a lower return for its stockholders.
So, why did Krispy Kreme reduce its financial leverage from 2000 to 2001? If fi-
nancial leverage increases return on equity, why not use a lot of financial leverage? There
is a cost to using a lot of debt in a company’s capital structure. That cost is higher risk.
Financial risk increases when a company uses a lot of debt because debt and interest
must be paid whether or not a company is profitable and creates operating cash flows.
Exhibit 8 illustrates the relationship between financial leverage and return on equity.


Exhibit 8
The Effect of Financial
Leverage on Risk and
Return
5%
Return




0


–5%



Return on
Assets
Low High Return on
Financial Leverage
Equity



The return on assets lines identify positive and negative returns of 5%. As a com-
pany’s financial leverage increases, its return on equity increases relative to its return
on assets when return on assets is positive. But when return on assets is negative, re-
turn on equity decreases relative to return on assets as financial leverage increases. Ac-
cordingly, financial leverage increases uncertainty about the returns that stockholders
will earn at a particular level of return on assets or for a particular amount of net in-
come. Uncertainty increases as the volatility of return increases. Return on equity varies
more (is more volatile) for higher amounts of financial leverage.
Therefore, companies trade off return for risk. Higher risk, in the form of higher
financial leverage, has the potential to create higher returns. But it also has the poten-
tial to create lower returns if a company is not profitable. As an example, if Krispy
Kreme had reported a net loss of $5,956,000 in 2000 rather than a net income, its re-
F373
CHAPTER F10: Analysis of Financing Activities
376 Analysis of Financing Activities

turn on assets would have been 5.7% and its return on equity would have been
12.5%. When a company’s earnings are negative, the use of debt in the capital struc-
ture results in a lower return for stockholders than when debt is not used.




2 SELF-STUDY PROBLEM Examine the information for Andromeda Company provided in
Self-Study Problem 1. Suppose Andromeda’s operating income
in 2004 is $70 million, as summarized below:



(In millions) 2004

Operating income $ 70
Interest expense (6)
Pretax income 64
Income taxes (22)
Net income $ 42
Assets:
Total assets $832
Liabilities:
Current liabilities $212
Long-term debt 75
Total liabilities 287
Stockholders’ equity 545
Total liabilities and equity $832




Required
A. Compute return on equity for Andromeda as reported above.
B. Compute the return on equity as it would be if the company issued $100 million
of long-term debt to repurchase stock. Additional interest expense would be $8 mil-
lion, and the tax rate is 35%.
C. What effect would the additional debt have on Andromeda’s risk and return?
The solution to Self-Study Problem 2 appears at the end of the chapter.



OTHER RISK CONSIDERATIONS
The fourth step in the analysis of financing activities involves evaluating the ability of
OBJECTIVE 6
each company to make debt and interest payments. Creditors and stockholders are con-
Use cash flow and cerned about a company’s ability to meet its obligations, including the payment of in-
liquidity measures to terest, as they become due. Debt ratios, such as the ratio of debt to total assets, provide
evaluate financing information that is helpful in evaluating default risk. Default risk is the likelihood that
decisions. a company will not be able to make debt or interest payments when they come due. As
the amount of debt in a company’s capital structure increases, the likelihood of default
increases because principal and interest payments become larger.
Therefore, though financial leverage can increase a company’s return on equity, the
amount of financial leverage a company can use is limited by the amount of principal
and interest the company can pay and still have enough cash to cover expenses, pur-
chase new assets, and pay dividends. Also, as financial leverage increases, the interest
rate demanded by creditors is likely to increase. Creditors demand higher returns as
compensation for the higher default risk of a company’s debt. Creditors may impose
limitations on a company’s ability to borrow additional money, require it to maintain
a certain debt ratio, or limit its ability to pay dividends unless certain ratios are main-
F374 SECTION F2: Analysis and Interpretation of Financial Accounting Information
377
Analysis of Financing Activities

tained. These limitations are called debt covenants, and they protect the interests of
creditors against a company becoming too risky or paying cash to stockholders when
it has too much debt.


Case in Point
In
Disclosure of Debt Covenants
A note in Krispy Kreme’s 2001 annual report describes its debt covenants:
The loan agreement entered into on December 29, 1999, requires us to maintain a
consolidated tangible net worth [stockholders’ equity] of $41 million through Janu-
ary 28, 2001. For each fiscal year thereafter, the agreement requires us to maintain
a consolidated tangible net worth of $41 million plus (1) an amount equal to 75%
of the net proceeds from our April 2000 initial public offering, and (2) 50% of our
net income for each fiscal year. Capital expenditures for each fiscal year are limited
to $35 million. The loan agreement also contains covenants which place various re-
strictions on sales of properties, . . . , the payment of dividends and other custom-
ary financial and nonfinancial covenants.




In addition to debt ratios, creditors consider cash flow and liquidity measures. A
commonly used liquidity measure is the current ratio: current assets divided by cur-
rent liabilities. If this ratio is low, especially if it is less than one, or if it decreases
substantially over time, the risk that a company may not be able to pay its current
obligations increases.
The current ratio for Krispy Kreme in 2001 was 1.77 ($67,611 $38,168). In 2000,
this ratio was 1.39 ($41,038 $29,586). Thus, Krispy Kreme substantially increased its
current assets in 2001 and increased its current ratio. Starbucks’ current ratio decreased
to 1.33 ($593,925 $445,264) in 2001 from 1.47 ($458,234 $311,666) in 2000. Note,
Starbucks’ current ratio was lower than Krispy Kreme’s in 2001. That means Krispy Kreme
was in a better position to meet its current liability obligations than was Starbucks.
Exhibit 9 provides selected cash flow information for Krispy Kreme and Starbucks.
Both companies reported positive operating cash flows and negative investing cash
flows. This pattern is common for many companies. Operating activities should pro-
vide a primary source of cash for a company. Cash created from selling goods and ser-
vices can be used to expand a company’s activities by investing the cash in additional
long-term assets. Thus, both Krispy Kreme and Starbucks were growing as a result of
reinvestment of cash flows into long-term assets.


Exhibit 9 Krispy Kreme Starbucks
Selected Cash Flow
(In thousands) 2001 2000 2001 2000
Information for Krispy
Kreme and Starbucks Net operating cash flow $ 30,576 $ 8,980 $ 460,826 $ 321,796
Net investing cash flow (67,288) (10,026) (433,053) (376,454)
Financing cash flow:
From issuing debt 3,526 4,282
From issuing stock 65,637 59,639 68,721
For purchase of stock (49,788)
For payment of dividends (7,005) (1,518)
For payment of long-term debt (22,901) (2,400) (685) (1,889)
Other financing activities 1,298 (448) 5,481 (7,776)
Net financing cash flow 40,555 (84) 14,647 59,056
Net change in cash $ 3,843 $ (1,130) $ 42,420 $ 4,398
F375
CHAPTER F10: Analysis of Financing Activities
378 Analysis of Financing Activities

Both Krispy Kreme and Starbucks generated large cash flows from their operating
activities in 2001. In 2001, Krispy Kreme’s operating cash flows to total assets was
17.8% ($30,576 $171,493). Starbucks’ ratio was 24.9% ($460,826 $1,851,039).
Thus, both companies had large amounts of cash to invest. The ratio of investing cash
flow to total assets was 39.2% ($67,288 $171,493) for Krispy Kreme and 23.4%
($433,053 $1,851,039) for Starbucks. Both companies were investing their cash in
additional assets, indicating that the companies were growing.
Krispy Kreme invested more cash than it created from operating activities during
2001. As indicated in Exhibit 9, the company financed these acquisitions by issuing ad-
ditional stock. A portion of the cash from the stock issue was used to repay long-term
debt. Starbucks also issued stock in 2001 (and in 2000). The shares were issued in con-
junction with stock option and employee stock purchase plans. To obtain shares needed
for these plans, Starbucks repurchased shares of its stock (Exhibit 9). Krispy Kreme re-
duced its financial leverage in 2001. Both companies were growing, using operating and
financing cash flows to pay for the growth.
Krispy Kreme paid dividends in 2001 and 2000. Starbucks did not make dividend
payments in either year. A measure of the relative size of dividend payments is the div-
idend payout ratio, the ratio of dividends to net income. Krispy Kreme’s dividend pay-
out ratio for 2001 was 47.8% ($7,005 $14,725) up from 25.5% ($1,518 $5,956) in
2000.
Krispy Kreme’s payment of large amounts of dividends was inconsistent with a high
growth strategy. Normally, growth companies retain most of their profits, reinvesting
them in additional assets. The dividends paid by the company in 2000 and 2001 were
part of a commitment to owners prior to the initial public sale of stock by the com-
pany in 2000. It was not the intent of the company to continue making dividend pay-
ments. A note in Krispy Kreme’s 2001 annual report states:

Krispy Kreme presently intends to retain its earnings to finance the expansion of its business and
does not anticipate paying cash dividends in the foreseeable future.

Krispy Kreme’s operations and financial position were better in 2001 than they had
been in previous years. Its net income, operating cash flow, and investing cash flow
(outflow) were much larger in 2001 than in 2000.
Both Krispy Kreme and Starbucks reduced their financial risks in 2001 by reduc-
ing their long-term debt. Consequently, in 2001, both companies were growing rapidly
and had relatively low financial risk.



FINANCING ACTIVITIES COMPANY VALUE
AND
The final step in the evaluation of financing activities is assessing the relationship be-
OBJECTIVE 7
tween financing decisions and company value. As we have seen from examining the fi-
Explain why financing nancing activities of Krispy Kreme and Starbucks, financing activities affect a company’s
activities are important risk and return. Financial leverage can work for or against a company and its stock-
for determining company holders. When a company does well, financial leverage can be useful. Stockholders earn
value. higher returns than they would if a company had no financial leverage. When a com-
pany is not doing well, financial leverage is detrimental. Stockholders earn lower re-
turns. In addition, creditors face higher default risk, and a company has less cash to
meet its other needs because it is forced to make interest and principal payments.
A measure of a company’s value to investors is the market-to-book-value ratio.
Market value is the price of a company’s stock times the number of shares of stock out-
standing. It is a measure of the total value placed on a company by the securities mar-
ket. Book value is the amount of stockholders’ equity reported by a company on its
balance sheet.
Krispy Kreme’s market value in 2001 was $442 million and its book value was
$125.679 million (Exhibit 7). Therefore, its market-to-book-value ratio was 3.52. In
practical terms, this ratio says that every dollar invested in Krispy Kreme by stock-
F376 SECTION F2: Analysis and Interpretation of Financial Accounting Information
379
Analysis of Financing Activities

holders, including retained earnings, was worth $3.52 at the end of the 2001 fiscal year.
In 2000, Krispy Kreme’s market-to-book-value ratio was 0.98. Consequently, Krispy
Kreme’s favorable operating results and lower financial risk resulted in much higher
value in 2001 than in 2000.
Starbucks’ market-to-book-value ratio was 6.08 in 2001. Starbucks was worth $6.08
at the end of the 2001 fiscal year for each dollar invested by stockholders. The com-
pany’s market-to-book-value ratio was 3.93 in 2000. Therefore, Starbucks, like Krispy
Kreme, gained value from 2000 to 2001.
Financing activities affect company value. A company that is performing well can
increase return to its stockholders by including debt in its capital structure. How much
debt a company uses depends on several factors. In particular, a company with stable
earnings and operating cash flows can afford more debt than one with unstable earn-
ings and cash flows. If a company runs the risk of not performing well (because of
volatile product markets or poor sales, for example), debt can increase the likelihood
that the company will earn lower returns and be unable to pay its creditors. A com-
pany that is growing rapidly already has a large amount of risk associated with its growth
activities. It is investing with the expectation that it will be able to earn high returns on
its investment in the future. Maintaining low financial risk can be advantageous, at least
until the company determines whether its investment strategy is working.
Company value also is affected by the purpose of financing activities. A company’s
value is likely to increase if it is using financing activities to acquire additional assets.
These assets help the company grow because it can use them to produce and sell more
products and earn additional income from these sales. If debt or stock is issued because
of operating cash flow problems, however, a company’s value is likely to decrease.
Exhibit 10 provides a summary of the ratios for Krispy Kreme and Starbucks that
have been presented in this chapter.



Exhibit 10 Krispy Kreme Starbucks
Summary of Ratios
Ratios 2001 2000 2001 2000
for Krispy Kreme and
Starbucks Return on Assets 8.6% 5.7% 9.8% 6.3%
Debt to Assets 26.7% 54.5% 25.7% 23.0%
Financial Leverage (Assets to Equity) 1.36 2.20 1.35 1.30
Return on Equity 11.7% 12.5% 13.2% 8.2%
Current Ratio 1.77 1.39 1.33 1.47
Operating Cash to Assets 17.8% 8.6% 24.9% 21.6%
Investing Cash to Assets 39.2% 9.6% 23.4% 25.2%
Dividend Payout 47.8% 25.5% 0.0% 0.0%
Market to Book Value 3.52 0.98 6.08 3.93




3 SELF-STUDY PROBLEM Data are provided on the next page for Alzona Company, a large
trucking company.

Required
A. Compute the following ratios for each year: debt (long-term) to assets, assets to
stockholders’ equity, return on assets, return on equity, current, dividend payout,
and market to book value.
B. Describe the company’s financing activities for 2004 and evaluate the effect they
had on the company’s stockholders.
The solution to Self-Study Problem 3 appears at the end of the chapter.
F377
CHAPTER F10: Analysis of Financing Activities
380 Analysis of Financing Activities


(In millions) 2004 2003

Current assets $ 433 $ 378
Total assets 1,237 1,065
Current liabilities 389 343
Long-term debt 422 404
Stockholders’ equity 426 318
Operating income 151 127
Interest expense (34) (31)
Income taxes (40) (33)
Net income 77 63
Operating cash flows 113 102
Investing cash flows (154) (112)
Financing cash flows 60 8
Debt issued 30 20
Debt repurchased (12) (10)
Stock issued 50 25
Dividends paid (20) (16)
Market value 643 512




REVIEW SUMMARY of IMPORTANT CONCEPTS


1. Capital structure refers to the relative amounts of debt and equity used by a company
to finance its assets.
a. The use of larger amounts of debt reduces net income because of additional interest
expense.
b. The use of larger amounts of debt also reduces the amount of equity a company
needs to finance its assets.
c. Therefore, additional debt increases return on equity when a company is perform-
ing well, but decreases return on equity when the company is performing poorly.
d. The amount of debt a company uses depends on its expectations about perfor-
mance, the potential volatility of its performance, and the amount of risk it is pre-
pared to take.

2. Debt increases a company’s risk.
a. Financial leverage magnifies a company’s returns, making them potentially more
volatile.
b. Debt increases risk because of the potentially negative effect on stockholder return
and the potential for default on debt and interest payments.
c. Debt also affects liquidity and cash flow. Interest and debt payments require the use
of cash. If a company does not have sufficient cash to meet these and other needs, it
may be unable to make payments when they are due.

3. Dividend policy is another financing decision.
a. The amount of cash dividends a company pays depends on the alternatives the
company has for using its cash.
b. If a company has good investment opportunities, stockholders may be better off
leaving cash in the company and letting management invest it in additional assets.
c. Stockholders benefit both from receiving dividends and from increases in stock
value because of company profitability and growth.

4. Investors can use accounting information to understand a company’s financing activities.
a. Analysis begins with identifying financing activities and profitability for one or
more periods or companies.
b. The second step is measuring capital structure.
c. The third step is evaluating the effect of financing decisions on risk and return.
F378 SECTION F2: Analysis and Interpretation of Financial Accounting Information
381
Analysis of Financing Activities

d. The fourth step is evaluating the effect of financing decisions on cash flows and de-
termining the ability of a company to make debt and interest payments.
e. The fifth step involves examining the relationship between a company’s financing
decisions and its market value.

5. Important ratios for analysis of financing activities of a company and for comparing
the results of those activities between different companies:
a. Return on equity (ROE): Net income divided by stockholders’ equity (which is also
equal to ROA times FL)—measures net income relative to the amount invested by
the owners of the company. The owners’ investment in the company includes not
only contributed capital but also retained earnings.
b. Debt-to-equity ratio: Total debt divided by total stockholders’ equity—measures the
company’s capital structure in terms of the relationship between the company’s
obligations to its creditors and the investment by the owners.
c. Debt-to-assets ratio: Total debt divided by total assets—measures the company’s
capital structures in terms of the proportion of total assets that are financed by
debt.
d. Return on assets (ROA): Net income divided by total assets—measures the amount
of return the company has earned from its assets.
e. Financial leverage (FL): Total assets divided by total stockholders’ equity—measures
how well the company has used debt to increase its return on equity.
f. Current ratio: Current assets divided by current liabilities—a liquidity measure of a
company’s ability to cover its current debts with its current assets.
g. Operating cash flow to total assets: Net operating cash flow divided by total assets—
measures the portion of net cash inflow (outflow) that contributed to (depleted) to-
tal assets.
h. Investing cash flow to total assets: Net investing cash flow divided by total assets—
measure the portion of net cash outflow (inflow) that was provided by (contributed
to) total assets.
i. Dividend payout ratio: Total dividends divided by net income—measures the por-
tion of net income that is paid to stockholders as dividends.
j. Market value: Total shares outstanding times the market value per share—measures
the total value placed on the company by the securities market.
k. Book value: Total assets minus total liabilities—measures the amount of stockhold-
ers’ equity on the balance sheet.
l. Market-to-book-value ratio: Market value of the entire company divided by the
book value of the entire company.



DEFINE TERMS and CONCEPTS DEFINED in this CHAPTER


capital structure (F363) financial leverage (FL) (F365)
current ratio (F374) return on equity (ROE) (F364)
F379
CHAPTER F10: Analysis of Financing Activities
382 Analysis of Financing Activities


SELF-STUDY PROBLEM SOLUTIONS
SSP10-1 A. Return on equity $49 $545 9.0%
B. Revised financial statement numbers:



(In millions) 2004

Sales $982
Cost of goods sold 607
Operating expenses 294
Operating income 81
Interest expense (20) $6 from old debt $14 from new
Pretax income 61
Income taxes (21) $61 0.35
Net income $ 40
Assets:
Current assets $277
Plant assets 555
Total assets $832
Liabilities:
Current liabilities $212
Long-term debt 275
Total liabilities 487
Stockholders’ equity 345
Total liabilities and equity $832
Return on equity $40 $345 11.6%




C. Issuing additional debt reduces net income because of the additional interest expense.
However, stockholder’s equity is reduced as well because the additional debt was used
to repurchase stock. Therefore, return on equity would be higher if the debt were is-
sued (increasing from 9% to 11.6%). Based on this information, increasing financial
leverage is a good decision for this company. Whether it will continue to be a good de-
cision in the future depends on whether the company continues to be profitable.

SSP10-2 A. Return on equity (as reported) $42 $545 7.7%
B. Financial statement effects of issuing $100 million of debt:



(In millions) 2004

Operating income $ 70
Interest expense (14) $6 from old debt $8 from new
Pretax income 56
Income taxes (20) $56 0.35
Net income $ 36
Assets:
Total assets $832
Liabilities:
Current liabilities $212
Long-term debt 175
Total liabilities 387
Stockholders’ equity 445
Total liabilities and equity $832
Return on equity $36 $445 8.1%
F380 SECTION F2: Analysis and Interpretation of Financial Accounting Information
383
Analysis of Financing Activities

C. Higher financial leverage increases risk. If net income and return on assets are low, fi-
nancial leverage reduces return on equity. If net income and return on assets are high,
financial leverage increases return on equity. Consequently, financial leverage may in-
crease or decrease return. It increases risk.
Andromeda’s return on equity in 2004 increases from 7.7% to 8.1% when the ad-
ditional debt is issued. However, uncertainty about future net income and return on
equity increases because of the increase in financial leverage. If Andromeda can con-
tinue to earn a profit, the additional debt should result in a higher return on equity in
the future than if the debt were not issued.

A.
SSP10-3
2004 2003
Debt to assets 0.34 $422 $1,237 0.38 $404 $1,065
Assets to stockholders’ equity 2.90 $1,237 $426 3.35 $1,065 $318
Return on assets 0.062 $77 $1,237 0.059 $63 $1,065
Return on equity 0.181 $77 $426 0.198 $63 $318
Current ratio 1.11 $433 $389 1.10 $378 $343
Dividend payout 0.260 $20 $77 0.254 $16 $63
Market to book value 1.51 $643 $426 1.61 $512 $318

B. Alzona’s primary financing activities in 2004 consisted of issuing additional debt ($18
million more than it repaid), issuing $50 million of stock, and paying $20 million of
dividends. The company’s performance was strong. Its net income and operating cash
flows were positive and increased from 2003 to 2004. Additional financing activities
were used to support investing activities. Additional assets were acquired in 2003 and
2004, indicating growth.
Alzona’s financial leverage decreased during 2004. Therefore, though its return on
assets increased from 2003 to 2004, its return on equity decreased. Thus, because the
company was performing well, stockholders would have benefited from an increase in
financial leverage. The decrease in financial leverage reduced stockholder return (return
on equity). The lower return on equity was accompanied by a decrease in company
value (market to book value). Both profitability and capital structure affect company
value.




Thinking Beyond the Question
How do we finance our business?


Financial decisions are critical for a company. It is important for a company to
create value for its owners by earning a high return and by controlling its risk.
Higher financial leverage can result in both high returns and high risk. Conse-
quently, managers must examine the tradeoff and choose an amount of finan-
cial leverage that is appropriate for their company. That amount will be different
for different companies. When is it appropriate for a company to have a large
amount of financial leverage? What kinds of companies are likely to have high
financial leverage? Why?
F381
CHAPTER F10: Analysis of Financing Activities

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