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384 Analysis of Financing Activities


QUESTIONS
What is capital structure? Why do the capital structures of companies vary?
Q10-1
Obj. 1

Why is return on equity such a valuable measure to investors?
Q10-2
Obj. 1

Company X and Company Y are both managed successfully by teams of highly respected ex-
Q10-3
ecutives. The firms operate in different industries. After careful analysis, you observe that Com-
Obj. 2
pany X employs a very high level of financial leverage while Company Y employs almost none.
How can both sets of executives be highly respected when their firms employ such different
levels of financial leverage?
Why would stockholders tend to believe that return on equity is a more important measure
Q10-4
of a company’s performance than is return on assets?
Obj. 2

Why does the use of financial leverage cause the current ratio to be lower than if no financial
Q10-5
leverage was used?
Obj. 3

Some companies, such as Microsoft, have never paid a dividend and are unlikely to do so any-
Q10-6
time soon. If an investment is never going to yield a dividend, why would anyone buy stock
Obj. 3
in such a company?
You are reviewing the balance sheets of Alpha Company and Beta Company. You observe that
Q10-7
Alpha has $800,000 of long-term debt and that Beta has $4,000,000. Which company is more
Obj. 4
highly leveraged? If you need additional information to answer this question, identify what
information you could use.
Beaumont Company has no current liabilities. Its only long-term debt is $20 million of bonds
Q10-8
payable. The company’s debt-to-assets ratio is 0.20 and its assets-to-equity ratio is 1.25. What
Obj. 4
is the company’s debt-to-equity ratio?
Does the use of financial leverage always have a favorable impact on the firm and its owners?
Q10-9
If not, explain the circumstances under which it would not be desirable to employ financial
Obj. 5
leverage.
How does the use of financial leverage affect the risk and return of a company?
Q10-10
Obj. 5

When a company issues long-term debt, creditors often require the company to agree to cer-
Q10-11
tain restrictions on future activities. For example, a restriction may limit a company’s debt-
Obj. 6
to-assets ratio and its dividend payout ratio. What is the purpose of these restrictions? How
do they benefit creditors?
Evaluate the following statement: Companies that issue a lot of new debt and equity to create
Q10-12
cash are usually in a bad financial condition.
Obj. 6

Ernesto wants some advice. He heard that some companies pay out a large portion of their
Q10-13
earnings as dividends to stockholders. Other companies pay few or no dividends. A friend told
Obj. 6
him that dividends affect the value of stock and that he should invest in stocks that pay high
dividend rates. What advice would you give Ernesto about this matter?
Applause Company has a market to book ratio of 0.75 to 1. Bravo Company has a market-
Q10-14
to-book-value ratio of 3.4 to 1. What information does the market-to-book-value ratio cap-
Obj. 7
ture and what does this ratio tell you about the companies mentioned?
What relationship would you expect between financial leverage and the market-to-book-value
Q10-15
ratio? Does a high value in one lead to a high value in the other? Or a low value in the other?
Obj. 7
Or do you think there is not necessarily a relationship? Explain your reasoning.
F382 SECTION F2: Analysis and Interpretation of Financial Accounting Information
385
Analysis of Financing Activities


If your instructor is using Personal Trainer in this course, you may complete online the assign-
EXERCISES ments identified by .
Write a short definition of each of the terms listed in the Terms and Concepts Defined in this
E10-1
Chapter section.
Describe how each of the following transactions affects the capital structure of a company. Is
E10-2
there an effect on the short-term liability portion, the long-term liability portion, the equity
Obj. 1
portion, or is there no effect at all?
a. The issuance of common stock
b. The sale of bonds
c. The purchase of equipment for cash
d. The purchase of inventory on credit
e. The purchase of treasury stock
f. The borrowing of cash, with a two-year note, from a bank
g. The declaration of dividends to stockholders
h. The payment of dividends
Given below is the most recent balance sheet of Carousel Company.
E10-3
Obj. 1


Carousel Company
Balance Sheet
at December 31, 2004

Assets Liabilities and equity
Cash $ 6,000 Accounts payable $ 3,100
Accounts receivable 13,200 Wages payable 3,000
Prepaid rent 2,800 Bonds payable (due 2008) 33,000
Inventory 10,000 Common stock 17,000
Machinery 14,000 Retained earnings 17,400
Land 13,500 Treasury stock (14,000)
Total assets $59,500 Total liabilities and equity $ 59,500




a. Describe the firm’s capital structure.
b. How would the capital structure be different if the company had raised the needed cap-
ital by issuing additional stock instead of the bonds that are due in 2008?
E10-4 Why is return on equity commonly used along with net income to evaluate a company’s per-
formance? Assume that a company issued long-term bonds during a fiscal period, increasing
Obj. 2
its interest expense. The bonds were used to finance new plant assets. What effect would the
financing and asset acquisition have on the company’s financial leverage? What effect should
the additional financing have on the company’s risk and return?
The following summary information is available regarding Robinson Sports Gear. The income
E10-5
statements are for the respective fiscal years, and the balance sheets are as of the end of each
Obj. 2
fiscal year.

Income Statements 2005 2004 2003 Balance Sheets 2005 2004 2003
Net sales $53 $48 $45 Total current assets $26 $13 $5
Cost of sales 31 28 27 Total long-term assets 41 22 9
Other expenses 15 15 15 Total liabilities 12 8 2
Net income $7 $5 $3 Total stockholders’ equity $55 $27 $12

a. What does this income statement information suggest to you about this firm and its at-
tractiveness as a potential investment?
b. Compute the return on equity for each of the three years.
c. How does the return on equity information change your initial conclusion about the
attractiveness of this company as an investment?
F383
CHAPTER F10: Analysis of Financing Activities
386 Analysis of Financing Activities

d. What do your responses to parts a and c suggest to you about evaluating a com-
pany?

A friend is studying for an accounting exam and exclaims, “I’m really confused by all this
E10-6
leverage stuff. What is leverage, anyway? How does it affect a company? And what has it got
Obj. 2
to do with the debt-to-equity ratio or debt-to-assets ratio? The professor keeps saying that a
company with a low debt-to-equity ratio might want to increase its leverage. What’s she talk-
ing about, anyway?” Write an explanation of these issues that your friend can use to study for
his exam.

At year end 2004, Istanbul Company had stockholders’ equity of $18 million. Stockholders’
E10-7
equity at year end 2004 consisted of one million shares of common stock. For 2004, the com-
Obj. 2
pany reported net income of $4 million. The company paid common dividends of $2 per
share in 2004. Compute Istanbul’s return on equity for 2004. What would this amount have
been if the company had issued bonds at the beginning of 2004 and had used the proceeds
to repurchase common stock, reducing stockholders’ equity at the end of 2004 to $14,540,000?
Assume net income decreased to $3.79 million as a result of additional interest expense, and
dividends per share remained at $2 per share for common stock.

E10-8 Boswell Company expects net income of $5 million for 2005. Pretax earnings are projected to
be $7 million. The company’s average total assets during 2005 were $25 million. It had no li-
Obj. 2
abilities or preferred stock. It had 1 million shares of common stock outstanding. Boswell is
considering issuing $10 million of debentures to repurchase 300,000 shares of its common
stock. If the debt had been outstanding in 2005, the company would have paid $900,000 in
interest expense. Calculate the company’s net income and return on equity for 2005 as re-
ported and as they would have been if the debt had been issued. Assume average stockhold-
ers’ equity of $15 million for computing return on equity with debt financing and that the tax
rate is 28.6%.

Kandahar Company had stockholders’ equity of $100 million in 2004 and long-term debt of
E10-9
$10 million. It had 10 million shares of common stock outstanding. Its interest expense was
Obj. 2
$800,000, and its income tax rate was 30%. The company expects that its annual income be-
fore interest and taxes will run between $5 million and $15 million for the foreseeable future.
The average is expected to be about $8 million. The company is considering issuing $25 mil-
lion of additional debt to replace three million shares of its common stock. The additional
debt would cost the company $3 million a year in interest. If you were asked by the company
for advice on whether to issue the debt, what advice would you give?

Linfield Company has assets of $200 million and long-term debt of $110 million. The debt
E10-10
consists primarily of callable debentures having interest rates ranging from 10% to 12%.
Obj. 2
(Callable debentures are bonds that a company can recall and pay off at any time it chooses.)
Over the last couple of years, the general level of interest rates has decreased by about 2.5%.
Linfield could issue new debt today at a rate of approximately 8%. Also, over the last two
years, Linfield’s stock price has increased about 30%. How might this information affect Lin-
field’s management when it considers financing decisions for the future?

Selected information is provided below for Georgia-Pacific Corporation from its 2001 an-
E10-11
nual report:
Objs. 2, 3


(In millions) 2001 2000 1999

Interest expense $1,080 $ 595 $ 426
Income tax expense 181 210 448
Net income (loss) (407) 505 1,116
Cash from operations 1,482 1,556 1,272
Total assets 26,364 29,418 15,505
Stockholders’ equity 4,905 5,722 3,875



Evaluate the effect of the company’s capital structure on its profitability, cash flow from op-
erations, and risk for the three years presented.
F384 SECTION F2: Analysis and Interpretation of Financial Accounting Information
387
Analysis of Financing Activities

Metro Flight Service reported net income of $8 million in 2005. Its average stockholders’ eq-
E10-12
uity of $22 million included preferred stock of $5 million that was outstanding throughout
Objs. 2, 3
the year. The company paid dividends of $2 million on common stock and $400,000 on pre-
ferred stock. (a) Calculate the company’s return on equity for 2005. (Note: When a company
has preferred stock outstanding, the preferred dividends must be deducted from the numer-
ator and preferred stock must be deducted from the denominator when computing returns
on equity.) (b) Management is thinking of issuing $5 million of additional common stock to
repurchase all of its preferred stock. Is the replacement of preferred stock with common stock
a good idea in this case?
Selected information from the year-end financial statements of Arabia Company is presented
E10-13
below. All amounts are in millions of dollars.
Obj. 3



2005 2004 2003 2002

Net income $ 36 $ 38 $ 42 $ 44
Interest expense 6 8 6 8
Current assets 64 66 64 60
Current liabilities 56 48 36 30
Total liabilities 122 116 118 102
Stockholders’ equity 400 382 376 340
Cash from operations 34 40 38 46




Management is considering the issuance of $200 million of new bonds that would pay 9% in-
terest. Based on the information presented here, how do you believe the financial markets will
respond to the proposed bond offering? Why or why not?
For each of the events or transactions below, indicate the effect on each ratio listed. Use I to
E10-14
indicate increase, D to indicate decrease, and NE to indicate no effect.
Objs. 2, 4

Debt to Debt to Financial Current
Equity Assets Leverage Ratio
a. Sold common stock to investors ____ ____ ____ ____
b. Borrowed cash from a bank on long-term note ____ ____ ____ ____
c. Paid cash dividends on stock ____ ____ ____ ____
d. Sold inventory for cash (at a small profit) ____ ____ ____ ____
e. Paid off loan in part b ____ ____ ____ ____
f. Bought stock of another company ____ ____ ____ ____
g. Purchased treasury stock ____ ____ ____ ____

E10-15 Intel Corporation reported the following information in its 2001 annual report:
Obj. 4


(In millions) 2001

Current Liabilities:
Short-term debt $ 409
Long-term debt, current portion 0
Total current liabilities 6,570
Long-Term Liabilities:
Long-term debt 1,050
Deferred income taxes 945
Stockholders’ Equity:
Common stock 8,833
Other (153)
Retained earnings 27,150
Total stockholders’ equity 38,830
F385
CHAPTER F10: Analysis of Financing Activities
388 Analysis of Financing Activities

Evaluate Intel’s capital structure. Explain which amounts you would include in a computa-
tion of the company’s debt-to-equity ratio and why.
E10-16 Selected information from the 2001 annual reports of Eastman Chemical Company and Mi-
crosoft is given below. All amounts are in millions.
Obj. 4



Eastman Chemical Microsoft

Current assets $1,458 $39,637
Total assets 6,086 59,257
Current liabilities 958 11,132
Long-term debt 2,143 0
Other long-term items 1,607 836
Total stockholders’ equity 1,378 47,289
Net income (179) 7,346




a. For each of the companies, compute the following values: (i) return on assets, (ii) total
assets to total equity, (iii) return on equity, (iv) long-term debt-to-equity ratio, and (v)
long-term debt-to-assets ratio.
b. Inspect the values you have computed for the items in a. What do these indicators tell
you about financing strategy and financing decisions that have been made by the man-
agement of these two firms? Have the decisions been similar or different? How have
these financing decisions affected returns to stockholders? Discuss.
Given below are selected data for Wal-Mart for the years ended January 31, 2002 and 2001:
E10-17
Obj. 4


2002 2001

Long-term debt to equity 0.45 0.40
Long-term debt to assets 0.19 0.16
Return on equity 20.1% 22.0%
Return on assets 8.5% 8.7%
Financial leverage 2.36 2.49
Current ratio 1.0 0.90




Study the information above and discuss what the changes from 2001 to 2002 mean. What
conclusion can you make about Wal-Mart’s financing activities?
Assume the following summarized balance sheet information at December 31, 2004:
E10-18
Obj. 4


Giffin Co. Good Co.

Current assets $35,000 $45,000
Long-term assets 65,000 55,000
Current liabilities 10,000 20,000
Long-term liabilities 60,000 10,000
Common stock, $10 par 25,000 60,000
Retained earnings 5,000 10,000
Operating income 40,000 40,000
Interest rate for long-term liabilities 10% 10%
Income tax rate 40% 40%


(Continued)
F386 SECTION F2: Analysis and Interpretation of Financial Accounting Information
389
Analysis of Financing Activities

a. Describe how these two firms compare regarding the use of leverage.
b. Is the firm with the higher degree of leverage using it effectively? Discuss. Show any
supporting computations clearly and neatly.
Given below is the most recent set of financial statements for BeanSprout Farms.
E10-19
Obj. 5
Income Statement for Year 2004
Balance Sheet at December 31, 2004
Sales revenue $82,000
Assets:
Cost of sales 51,000
Cash $ 6,000
Gross margin $31,000
Marketable securities 2,800
Expenses:
Accounts receivable 5,200
Wages 14,000
Inventory 5,000
Depreciation 2,000
Machinery, net 21,000
Interest 1,000
Land 10,500
Bad debts 3,000 20,000
Total assets $50,500
Pretax income 11,000
Taxes (30%) 3,300
Liabilities and Equity:
Net income $ 7,700
Accounts payable $ 3,100
Notes payable (due 2008) 12,000
Common stock ($1 par) 4,000
Paid-in capital 16,000
Retained earnings 15,400
Total liabilities and equity $50,500

a. Calculate return on assets and return on equity.
b. Assume the company had $18,000 less of contributed capital and $18,000 more of
long-term debt. Recalculate return on assets and return on equity.
c. Assume the company replaced all its long-term debt with equity capital. Recalculate re-
turn on assets and return on equity.
d. Discuss how financial leverage affects return on assets and return on equity as shown in
the results above.
E10-20 Information from the annual reports of two companies is provided below:
Objs. 3, 6


(In millions) 2002 2001 2000
General Mills
Net income 458 665 614
Dividends 358 312 329
Wal-Mart
Net income 6,671 6,295 5,377
Dividends 1,249 1,070 890




What do the dividend policies indicate about future prospects for the two companies?
Data from the 2001 annual reports of J.C. Penney and Home Depot are shown below. The
E10-21
objective of this assignment is to determine which company is more highly regarded by the
Obj. 7
financial markets.



J.C. Home
Penney Depot

Common stockholders’ equity (millions) $6,129 $18,082
Common shares (millions) 264 2,346
Market price per common share $23.70 $49.40
F387
CHAPTER F10: Analysis of Financing Activities
390 Analysis of Financing Activities

a. In general, what information is revealed by computation of the market-to-book-value
ratio?
b. Compute the market-to-book-value ratio for J.C. Penney and Home Depot.
c. What do you conclude from the results of the market-to-book-value ratios of the two
companies?
Data are provided below for Register Company, a large security company. All amounts are in
E10-22
millions of dollars.
Obj. 7


Year 2005 Year 2004

Current assets $ 736 $ 643
Total assets 2,103 1,810
Current liabilities 541 475
Long-term debt 862 815
Stockholders’ equity 700 520
Operating income 241 200
Interest expense (58) (53)
Income taxes (68) (56)
Net income 115 91
Operating cash flows 192 173
Investing cash flows (262) (190)
Financing cash flows 102 14
Debt issued 51 34
Debt repurchased (20) (17)
Stock issued 85 43
Dividends paid (34) (27)
Market value 1,093 870




a. Compute the following ratios for each year: debt (long-term) to assets, assets to stock-
holders’ equity, return on assets, return on equity, current ratio, dividend payout, and
market to book value.
b. Identify and describe the company’s financing activities for 2005. Be specific.
c. Evaluate the effects the firm’s financing activities had on the company’s stockholders.



If your instructor is using Personal Trainer in this course, you may complete online the assign-
PROBLEMS ments identified by .

Capital Structure and Return on Equity
P10-1
Obj. 2 Financial statement information is presented on the next page for Platform Corporation, a
manufacturer. Platform is considering a change in its capital structure. Management has pro-
posed issuing $150 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 $150 million. The interest expense on the additional debt
would be $9 million. The company’s tax rate is 30% of pre-tax income.

Required
A. Compute Platform’s return on equity for 2004 as reported.
B. Compute what Platform’s return on equity would have been in 2004 if the company had
issued the additional debt and had repurchased common stock before the year began.
You will need to recompute net income beginning with operating income. Also, recom-
pute liabilities and equity on the balance sheet. Round to the nearest million dollars.
C. Based on these computations, would the change in capital structure be good for Plat-
form’s stockholders? Explain your reasoning.
(Continued)
F388 SECTION F2: Analysis and Interpretation of Financial Accounting Information
391
Analysis of Financing Activities

Income Statement Balance Sheet
Fiscal Year 2004 (In millions) At Year-end (In millions)
Sales $ 893 Assets:
Cost of goods sold (552) Current assets $252
Operating expenses (267) Plant assets 505
Operating income 74 Total assets $757
Interest expense (8) Liabilities and Equity:
Pretax income 66 Current liabilities $197
Income taxes (20) Long-term debt 100
Net income $ 46 Total liabilities 297
Stockholders’ equity 460
Total liabilities and
stockholders’ equity $757



P10-2 Observing Changes in Capital Structure from Comparative Balance
Sheets
Objs. 1, 2, 4
Shown below are comparative balance sheets for Claudia Company at December 31.



2005 2004

Assets:
Cash $ 12,000 $ 7,400
Accounts receivable 16,200 8,100
Inventory 10,000 8,000
Prepaid rent 5,600 5,100
Machinery, net 28,000 30,000
Land 27,000 27,000
Total assets $ 98,800 $85,600
Liabilities and Equity:
Accounts payable $ 6,200 $ 5,800
Wages payable 5,800 6,100
Bonds payable (long-term) 46,000 16,400
Common stock 34,000 34,000
Retained earnings 34,800 26,400
Treasury stock (28,000) (3,100)
Total liabilities and equity $ 98,800 $85,600




Net income for 2005 was $8,400. In 2004, it was $7,300.

Required
A. Identify the changes in capital structure that occurred during fiscal 2005.
B. Compute the (long-term) debt-to-equity ratio and (long-term) debt-to-assets ratio for
both 2004 and 2005.
C. What were the return on assets and return on equity in 2004?
D. What were the return on assets and return on equity in 2005?
E. What role did the changes in capital structure have on return on assets and return on
equity in 2005?

Comparing Capital Structures
P10-3
Obj. 4 Financial information from the 2001 annual reports of two companies is provided on the next
page. Intel Corporation is a manufacturer of semiconductors (primarily computer micro-
processors). Pacific Gas & Electric is a privately owned utility.
F389
CHAPTER F10: Analysis of Financing Activities
392 Analysis of Financing Activities


(In millions) (In millions)
Intel Corporation 2001 Pacific Gas & Electric 2001

Current assets $17,633 Current assets $ 9,773
Plant assets, net 18,121 Plant assets, net 19,167
Other noncurrent assets 8,641 Other noncurrent assets 6,922
Total assets 44,395 Total assets 35,862
Current liabilities 6,570 Current liabilities 2,544
Long-term debt 1,050 Long-term debt 3,019
Other noncurrent liabilities 945 Other noncurrent liabilities 5,355
Preferred stock 0 Preferred stock 437
Stockholders’ equity 35,830 Common stock equity 2,398




Required
A. Identify at least three measures that can be used to assess capital structure. Compute
their values for these two companies. (Hint: Treat preferred stock as a liability.)
B. Compare and contrast the capital structures of the two companies.
C. Why might these differences in capital structure exist between the two companies?


Evaluating Financing Alternatives
P10-4
Obj. 4 Information is provided below for the Baker Mountain Company.


(In thousands, except per share amounts) 2004

Operating income $ 306,679
Interest expense (55,528)
Income taxes (40%) 122,517
Net income 176,350
Earnings per share (144.6 million shares) 1.23
Total assets 3,297,390
Short-term borrowing 1,612
Current portion of long-term debt 247
Total current liabilities 635,320
Long-term debt 673,588
Deferred income taxes 150,460
Other long-term liabilities 51,178
Total stockholders’ equity 1,689,209




Assume that during 2004, Baker Mountain Company had the opportunity to acquire addi-
tional assets at a price of $500 million. The additional assets were expected to increase the
company’s operating income by $80 million annually (to $386,679,000) for the foreseeable fu-
ture. They could be financed either by selling stock or issuing debt.

Required Prepare a pro forma (projected) income statement for each financing alternative.
Start with operating income. Compute pro forma return on assets and pro forma return on
equity under each alternative. Discuss whether Baker Mountain should finance the acquisi-
tion with debt or stock. Assume that debt could be issued at a 7% interest rate.


Evaluating Financing Alternatives
P10-5
Obj. 4 Given on the next page are the balance sheet and income statement for fiscal 2004 for the
Crossroads Company.

(Continued)
F390 SECTION F2: Analysis and Interpretation of Financial Accounting Information
393
Analysis of Financing Activities

Balance Sheet Income Statement
Assets: Sales revenue $358,000
Cash $ 14,000 Cost of sales 227,000
Inventory 42,000 Gross margin 131,000
Investments 11,000 Interest expense (5,000)
Buildings (net) 47,000 Other fixed expenses (70,000)
Land 37,000 Taxes (40%) (22,400)
Total assets $151,000 Net income $ 33,600
Liabilities and Equity:
Accounts payable $ 17,000
Notes payable 32,000
Common stock 61,000
Retained earnings 41,000
Total liabilities and equity $151,000

Crossroads Company plans to purchase new productive equipment, for $200,000, that will in-
crease the company’s revenues by 20% during 2005. Management would like to maintain the
company’s current return on equity if at all possible. Crossroads can finance the purchase by
selling stock or issuing long-term debt at 6% interest.

Required
A. Prepare a pro forma (projected) income statement for 2005 assuming the new equip-
ment is financed through the issuance of new equity.
B. Prepare a pro forma (projected) income statement for 2005 assuming the new equip-
ment is financed through the issuance of new long-term debt.
C. Assess the company’s two options and make a recommendation for financing the new
equipment that best matches management’s objective. Can you think of any other al-
ternatives that management might consider?

Analyzing Financing Activities and Capital Structure
P10-6
Obj. 4 Presented below is condensed and summary information from the financial statements of
Tommy Hilfiger Corporation.



Consolidated Balance Sheets March 31, March 31,
(In thousands, except share data) 2002 2001

Assets:
Current assets $ 893,888 $ 851,644
Property and equipment, net 302,937 281,682
Intangible assets 1,390,092 1,206,358
Other assets 7,534 2,872
Total Assets $ 2,594,451 $ 2,342,556
Liabilities and shareholders’ equity:
Current liabilities $ 302,697 $ 260,268
Long-term debt 575,287 529,495
Other noncurrent liabilities 219,005 204,200
Shareholders’ equity* 1,497,462 1,348,593
Total liabilities and
shareholders’ equity $ 2,594,451 $ 2,342,556
*Common shares outstanding 96,031,167 95,169,402




Required
A. Analyze the capital structure of Tommy Hilfiger Corporation and discuss your findings.
B. Analyze Tommy Hilfiger’s liquidity and discuss your findings. (Hint: Assume the aver-
age current ratio of companies in this industry is 1.84.)
F391
CHAPTER F10: Analysis of Financing Activities
394 Analysis of Financing Activities

Evaluating the Effects of Financial Leverage
P10-7
Objs. 4, 5 Information is provided below from the 2001 annual report of Pacific Gas & Electric.


(In millions) 2001 2000

Operating income (loss) $ 2,478 $(5,201)
Interest expense 974 619
Pretax income (loss) 1,611 (5,637)
Income taxes (benefit) 596 (2,154)
Net income (loss) 1,015 (3,483)
Total assets 35,832 36,152
Total stockholders’ equity 2,398 1,410
Long-term debt 3,019 3,342




The interest expense relates primarily to the long-term debt.

Required
A. Calculate the company’s return on equity for 2001 and 2000.
B. How much did the company’s financial leverage help or hurt the stockholders each year?
C. What would have happened to return on equity in these two years if, prior to 2000, the
company had sold more common stock and used the proceeds to pay off debt?

Identifying Capital Structure Choices
P10-8
Objs. 3, 5 You are a financial manager with a medium-sized company, Kangaroo Express. The company
is owned and managed by the Marsupial family. Currently, 60% of the company’s financing
is composed of long-term notes, 20% is current liabilities, and the remainder consists of stock
held by members of the Marsupial family. You have been asked to meet with the company’s
top management to discuss the company’s capital structure and plans to raise capital for ex-
pansion.

Required Write a short report describing alternative types of financing Kangaroo Express
might consider. Explain the risk and return implications of each alternative for the Marsupials.

Comparing Capital Structures and the Effect of Leverage
P10-9
Objs. 4, 5 Given below are summary financial statements for two companies.


2005 2004 2003

Clipper Company:
Total assets $6,000 $5,500 $5,000
Total liabilities 3,273 4,014 3,750
Net income 300 200 100
Dividends 75 50 25
Battle Company:
Total assets $7,000 $6,000 $5,000
Total liabilities 5,333 4,286 3,333
Net income 300 200 100
Dividends 150 100 50




Required
A. Compute the debt-to-equity ratios for, and compare the capital structures of, the two
companies.
(Continued)
F392 SECTION F2: Analysis and Interpretation of Financial Accounting Information
395
Analysis of Financing Activities

B. Compute and compare the return on equity, return on assets, and financial leverage
factors of the two companies.
C. Compute and compare the dividend payout ratios of the two companies.
D. After this analysis, which company would you prefer to invest in and why?

Evaluating the Effect of Financial Leverage on Risk
P10-10
Obj. 5 Information is provided below for two companies, describing likely outcomes for the com-
panies in various economic circumstances.


Halyard Company Spinnaker Company
Bad Normal Good Bad Normal Good
Year Year Year Year Year Year

Assets $800 $800 $800 $800 $800 $800
Debt 200 200 200 600 600 600
Equity 600 600 600 200 200 200
Net income (25) 75 175 (25) 75 175




Required
A. Calculate the following ratios for each company. Interpret the results of your calcula-
tions and explain what you conclude from the ratios.
i. Debt-to-equity ratio
ii. Debt-to-assets ratio
B. Calculate the following for each company under each economic circumstance.
i. Return on assets
ii. Financial leverage
iii. Return on equity
C. Evaluate the effect of financial leverage on the risks of the two companies.

Evaluating the Effect of Financial Leverage
P10-11
Obj. 5 Information is provided below for two companies that have the same capital structure but dif-
ferent amounts of net income for the three years presented:


James Company: 2005 2004 2003

Assets $3,000 $2,000 $1,000
Debt 1,800 1,200 600
Equity 1,200 800 400
Net income (loss) 1,000 500 250

Joyce Company: 2005 2004 2003

Assets $3,000 $2,000 $1,000
Debt 1,800 1,200 600
Equity 1,200 800 400
Net income (loss) (400) (200) 300




Required
A. Calculate the following ratios for each company for each of the three years given:
1. Debt-to-equity ratio
2. Debt-to-assets ratio
3. Return on assets
4. Financial leverage
5. Return on equity
F393
CHAPTER F10: Analysis of Financing Activities
396 Analysis of Financing Activities

B. Graph the results of the return on assets and return on equity calculations, putting the
three years along the X (horizontal) axis and the percentages along the Y (vertical) axis.
Discuss your conclusions.
C. For each company, reverse the amounts shown for debt and equity on the previous
page. (For example, in 2005 both companies would have $1,200 of debt and $1,800 of
equity.) Repeat the requirements for parts A and B. Discuss your conclusions and how
they differ from the results you obtained in part B.

Additional Debt, Capital Structure, and Return on Equity
P10-12
Obj. 5 Louisiana Company’s fiscal year 2004 operating results and year-end balance sheet are as shown
below.

Partial 2004 Income Statement
(in millions) Year-end 2004 Balance Sheet
Operating income $122 Total assets $1,514
Interest expense (16) Liabilities:
Pretax income 106 Current liabilities $ 394
Income taxes (30%) (32) Long-term debt 200
Net income $ 74 Total liabilities 594
Stockholders’ equity 920
Total liabilities and
stockholders’ equity $1,514

Required
A. Compute return on equity for the company based on the information reported above.
B. Determine what the company’s return on equity would have been in 2004 if, before the
year began, the company had issued $225 million of additional long-term debt (at 8%
interest) and had repurchased common stock. (Hint: You will need to recompute net
income, liabilities, and stockholders’ equity. Round financial statement amounts to the
nearest million dollars.)
C. What effect would the additional debt have on the company’s risk and return?

P10-13 Analyzing Performance and the Effect of Financial Leverage
Obj. 5
The following financial statement information is from the annual report of Best Buy, Inc., a
large retailer of electronics.



Consolidated Statements of Operations
(In millions, except per share amounts)

For the fiscal years 2002 2001 2000
Net revenue $19,597 $15,327 $12,494
Cost of goods sold 15,167 12,268 10,101
Gross profit 4,430 3,059 2,393
Selling, general, and
administrative expense 3,493 2,455 1,854
Operating income 937 604 539
Net interest revenue (1) 37 24
Earnings before income taxes 936 641 563
Income tax expense 366 245 216
Net income $ 570 $ 396 $ 347
Total assets $ 7,375 $ 4,840 $ 2,995
Stockholders’ equity 2,521 1,822 1,096



Required
A. Analyze the profit performance of Best Buy, Inc., and discuss your findings.
B. Analyze the effect of financial leverage on Best Buy, Inc., and discuss your findings.
F394 SECTION F2: Analysis and Interpretation of Financial Accounting Information
397
Analysis of Financing Activities

Evaluating Financing Cash Flows
P10-14
Objs. 3, 4, 6 Information is provided below from the 2001 annual report of Johnson & Johnson:



(In millions) 2001 2000

Cash flows from financing activities:
Dividends to stockholders $(2,047) $(1,724)
Repurchase of common stock (2,570) (973)
Proceeds from short-term debt 338 814
Retirement of short-term debt (1,109) (1,485)
Proceeds from long-term debt 14 591
Retirement from long-term debt (391) (35)
Proceeds from the exercise of stock options 514 387
Net cash used by financing activities $(5,251) $(2,425)




Required Evaluate Johnson & Johnson’s financial condition from the information provided.
Do the financing activities indicate that the company is facing financial problems? Explain
your thinking. What effect have these activities had on the company’s capital structure?

Analyzing Credit-Paying Ability
P10-15
Objs. 3, 4, 6 Sunny Meadow Enterprises disclosed the following information in its 2004 annual report:



(In millions) 2004 2003

Net income (loss) $ (31.0) $ 58.6
Net cash flow from operating activities 6.8 144.2
Net cash flow from financing activities 135.8 (339.6)
Interest payments 65.9 81.4
Current portion of long-term debt 27.7 31.6
Total current liabilities 357.2 344.0
Total liabilities 1,384.3 1,210.9
Total current assets 695.9 626.3
Total assets 2,160.5 2,073.5




You are a financial analyst with a large investment company. Several clients are creditors and
stockholders of the company. One client in particular, Wellington Smythe, has expressed con-
cern about the company’s recent net loss. He is concerned about the company’s ability to meet
its principal and interest payments and the effect of this on the company’s stockholders.

Required Write a memo to Wellington explaining whether you think he should be con-
cerned about the company’s ability to meet its obligations and whether stockholders should
be concerned about the company’s performance. Use relevant information from the data pre-
sented above to support your explanations.

Analyzing Capital Structure Decisions
P10-16
Objs. 4, 5, 6 Companies are sometimes acquired by investors using a technique called a leveraged buyout
(LBO). Selected information for a company both before and after such a transaction is given
on the next page. The information is typical of an LBO.

Required
A. From the information for the years before and after the LBO, how would you define an
LBO?
B. In the year after the LBO, how could Interest Expense exceed Interest Paid?
F395
CHAPTER F10: Analysis of Financing Activities
398 Analysis of Financing Activities

C. Is the company more risky or less risky after the LBO? Discuss.
D. After the LBO, net income was drastically reduced. Do you think the firm is in imme-
diate danger? Discuss.



Year After Year Before
(In millions) the LBO the LBO

Net income (loss) $ (747) $ 786
Operating income 1,334 1,498
Interest expense 1,909 318
Interest paid in cash 1,293 318
Cash provided by operations 1,687 1,901
Current maturities of long-term debt 1,711 105
Total current liabilities 3,269 2,680
Long-term debt 14,266 2,525
Stockholders’ equity 804 3,925




Evaluating Financing Cash Flows
P10-17
Objs. 6, 7 Add the following excerpts from the statement of cash flows from Tommy Hilfiger Corpora-
tion to the information provided in Problem 10-6.


Consolidated Statements of Cash Flows
For the Fiscal Year Ended March 31

(In thousands) 2002 2001 2000
Cash flows from operating activities $ 353,300 $ 190,968 $ 231,209
Cash flows from investing activities $(301,984) $ (73,890) $(151,984)
Cash flows from financing activities
Proceeds of long-term debt $ 144,921 — $ 20,000
Payments on long-term debt (155,538) (50,000) (40,000)
Proceeds from the exercise
of stock options 7,997 3,710 8,933
Purchase of treasury shares — (61,231) —
Short-term bank borrowings
(repayments), net 20,120 (523) (711)
Net cash provided by (used in)
financing activities $ 17,500 $(108,044) $ (11,778)



In addition, Tommy Hilfiger Corporation provided the following information and quotation
in the section of its annual report entitled “Market for Registrant’s Common Equity And Re-
lated Matters.”

High Low
Fiscal year ended March 31, 2002
Fourth quarter 16.06 11.20
Fiscal year ended March 31, 2001
Fourth quarter 17.25 9.06

“Tommy Hilfiger Corporation has not paid any cash dividends since its IPO in 1992, and has
no current plans to pay cash dividends.”

Required
A. Describe and summarize the company’s financing cash flows for the fiscal periods cov-
ered by the information provided.
(Continued)
F396 SECTION F2: Analysis and Interpretation of Financial Accounting Information
399
Analysis of Financing Activities

B. Besides the quotation from the annual report, how else do you know that the company
has not been paying dividends?
C. Compute the market to book value at the points in time for which you have the neces-
sary information available in the problem. Describe any changes over that period that
you observe.

Ethical Issues in Financing Decisions
P10-18
Objs. 6, 7 Randy Slowpush is chief financial officer (CFO) for Endrun Financial Corp. Because the
rapidly growing company wishes to maximize financial leverage, the company is in constant
need of new debt capital. As CFO, Randy is famous for creative financing techniques by
which the firm is able to raise money without reporting the debt on its own balance sheet.
A common technique is to establish a partnership, partially owned by Randy, that borrows
money to finance certain business ventures on behalf of Endrun Corp. Endrun secretly guar-
antees the loans by pledging to issue its own stock, if necessary, to repay the partnership
loans.
Randy then negotiates contracts with Endrun, on behalf of the partnerships, to manage
specified business activities for Endrun. Often he negotiates with Endrun employees who re-
port to the CFO. In 2002, Randy earned $30 million from operating about 15 of these part-
nerships. Endrun benefits from this arrangement by keeping the debt off its books, which
keeps its leverage ratios in an acceptable range, which keeps its interest rates low on the debt
it does report. Stockholders and creditors are not aware of these arrangements.

Required Are these activities unethical? Why or why not?

Evaluating Financing Choices
P10-19
Obj. 6 Aitken Company needs cash. The company has several hot new products and sales are grow-
ing rapidly. The controller has just presented CEO Jim Aitken the following balance sheet up-
dated through today, saying, “we’ve got to raise $90,000 cash immediately.”

Assets Liabilities
Cash $ 11,200 Accounts payable $ 18,550
Accounts receivable 15,000 Other short-term liabilities 39,550
Inventory 10,000 Long-term debt 100,000
Machinery, net 107,500 Stockholders’ equity
Buildings, net 253,600 Contributed capital 200,000
Land 80,000 Retained earnings 119,200
Total assets $477,300 Total liabilities and equity $477,300

The controller proposed three options to raise the $90,000: (1) obtain a short-term bank loan,
(2) sell new shares of common stock, or (3) issue long-term bonds payable. She also presented
the CEO with the following information about financial ratio benchmarks for companies in
their industry.

Ratio High Average Low
Current ratio 2.5 1.5 1.0
Long-term debt to equity 0.28 0.40 0.53
Long-term debt to assets 0.19 0.26 0.35
Assets to equity 1.3 1.7 2.0

Required
A. Compute today’s value of the four ratios for which benchmarks are given.
B. Evaluate each value computed in part A with its industry benchmark. Which ratio val-
ues are strong? Which are weak?
C. Compute pro-forma (projected) ratio values under each of the three financing options.
That is, for each option, what would be the new ratio values immediately after that op-
tion was implemented?
D. Evaluate your results from part C. Which financing option would best strengthen the
company’s financial position as measured by the four ratios considered? Explain.
F397
CHAPTER F10: Analysis of Financing Activities
400 Analysis of Financing Activities

Excel in Action
P10-20
The Book Wermz issued common stock and bonds in March 2005. Following that, the com-
pany created projected income statement and balance sheet account balances for the fiscal year
ended December 31, 2005 that appear below. Only selected balances are presented.

Operating income $ 647,585
Total assets 5,623,107
Long-term debt 2,097,416
SPREADSHEET
Stockholders’ equity 3,370,241

Assume that interest expense is 9% of long-term debt and the company’s income tax rate is 35%.

Required Enter the data shown above for The Book Wermz in columns A and B of a spread-
sheet. Calculate interest expense, pretax income, income taxes, and net income for the com-
pany for 2005 using the assumptions provided. Then, calculate return on assets, financial
leverage (Assets Stockholders’ Equity), and return on equity. Place captions in column A
and amounts in column B.
Copy the data from column B to column C. Assume that the company’s long-term debt
decreased by $1 million and its stockholders’ equity increased by $1 million. Adjust these
amounts in the spreadsheet. What effect would this change have on the company’s return?
Copy the data from column C to column D. Assume that the company’s long-term debt
increased by $1 million and its stockholders’ equity decreased by $1 million relative to the
amounts in column B. Adjust these amounts in the spreadsheet. What effect would this change
have on the company’s return?
Suppose that the company’s operating income for 2005 was $200,000. What effect would
this change have on the company’s return under each of the scenarios described above? Copy
columns B, C, and D to columns E, F, and G and change the operating income in columns E,
F, and G to $200,000.
Graph the relation between financial leverage and return on equity. Select the rows in
which these two calculations appear on your spreadsheet. Click on the Chart Wizard but-
ton. Select XY (Scatter) as the chart type and click the Next button. Make sure the Rows but-
ton is checked in the Series field. Click the Next button. In the Titles tab, enter “Effect of
Financial Leverage on Return” for the chart title. Enter “Financial Leverage” for the Value (X)
axis, and “Return on Equity” for the Value (Y) axis. In the Legend tab, click the Show Leg-
end box so the checkmark is removed. Click the Next button. Click on the As object in but-
ton and then the Finish button. You can resize the chart by clicking on it, clicking any of the
small boxes around the edge of the chart and dragging the chart to the size and shape you
want. You can move the entire chart by clicking on the chart (not one of the boxes) and drag-
ging it to a new location. Various parts of the graph can be reformatted by clicking on the
graph item with the right mouse button and selecting Format from the dialog box. For ex-
ample, if you want to remove the shading from the plot area, click on the shaded area with
the right mouse button, select Format Plot Area, and click on the None button in the Area
category. You can change colors, fonts, axes, numbers of decimals, and other properties us-
ing this method.
What can you conclude about the relation between financial leverage and return on equity?

Multiple-Choice Overview of the Chapter
P10-21
1. The way a company finances its assets and operating activities is its
a. capital structure.
b. financial leverage.
c. return on equity.
d. present value.
2. Honey Farms Company reported the following information.
Net sales $ 85
Net income 10
Total assets 103
Total liabilities 41
Stockholders’ equity 62
(Continued)
F398 SECTION F2: Analysis and Interpretation of Financial Accounting Information
401
Analysis of Financing Activities

Return on equity is
a. 6.2%.
b. 9.7%.
c. 11.8%.
d. 16.1%.
3. Financial leverage always
a. increases profits.
b. decreases profits.
c. increases risk.
d. decreases risk.
4. Which of the following ratios is an indicator of liquidity?
a. Debt to assets
b. Current assets to current liabilities
c. Assets to equity
d. Net income to equity
5. Financing with capital leases and financing with preferred stock are similar in that both
a. require the payout of fixed amounts each period.
b. increase the amount of net income available to common stockholders.
c. increase the riskiness of the firm’s common stock.
d. cause cash flow from operations to be smaller than it otherwise would be.
6. At year end, J. J. Walker Company had total assets of $90,000 and total stockholders’
equity of $50,000. The firm’s return on assets was 12% for the year. What were net in-
come and return on equity?
Net Income Return on Equity
a. $4,800 9.6%
b. $6,000 12.0%
c. $10,800 21.6%
d. $16,800 33.6%
7. Crispy Chips, Inc. earned net income this past year of $100,000 on assets of $1.9 mil-
lion and stockholders’ equity of $1.2 million. To raise $500,000 of additional capital,
Crispy can either issue long-term debt paying 9% interest or issue additional common
stock. Use of the new capital should raise net income, before considering any new in-
terest cost, by $68,000. To maximize return on equity, Crispy should
a. not issue any new debt or equity.
b. issue new equity only.
c. issue new debt only.
d. issue half in new equity and half in new debt.
8. High amounts of financial leverage are most common for companies with
a. small proportions of plant assets and stable earnings.
b. large proportions of plant assets and stable earnings.
c. small proportions of plant assets and unstable earnings.
d. large proportions of plant assets and unstable earnings.
9. Low dividend payout ratios are common for companies
a. with low growth potential.
b. in stable industries.
c. with high growth potential.
d. with stable earnings.
10. If a company is having difficulty paying interest and principal on its debt, creditors
should be particularly concerned with
a. its return on assets.
b. its return on equity.
c. its debt to equity ratio.
d. its cash flows.
F399
CHAPTER F10: Analysis of Financing Activities
402 Analysis of Financing Activities


Projects
CASES
Evaluating Capital Structure
C10-1
Obj. 4 Selected information for Terabyte Technology, Inc. is provided below:


(In millions except per share amounts) 2005 2004

Earnings before interest and taxes $ 742 $ 799
Interest expense 129 133
Earnings before income taxes 613 666
Income taxes 159 167
Net income 454 499
Net income per share 3.44 3.80
Average shares outstanding 131.9 131.3
Total current assets 4,487 4,452
Total assets 9,375 8,742
Total current liabilities 3,063 3,048
Long-term debt 954 792
Deferred income taxes 196 203
Other liabilities 532 442
Total stockholders’ equity 4,630 4,257
Net cash provided by operations 1,358 1,307
Net cash used for investing activities (1,232) (1,443)
Net cash provided by financing activities:
Increase (decrease) in notes payable and
current portion of long-term debt (143) 208
Increase in long-term debt 135 7
Issuance of common stock 19 55
Payment of dividends (100) (100)
Net cash provided by (used for) financing activities (89) 170



Required Write a short report describing Terabyte’s capital structure. Consider changes in
the company’s capital structure in 2005, and identify the causes of these changes. Identify Ter-
abyte’s primary source of financing in 2005, and evaluate the company’s financial condition
at the end of 2005.

Evaluating Capital Structure Decisions
C10-2
Objs. 4, 5 At year end 2004, the capital structure of Hard Luck Casino, Inc. was as follows:

Current liabilities $ 2,400,000
Long-term debt (9% bonds) 5,000,000
Preferred stock, $100 par 1,000,000
Common stock, no par value 15,000,000
Retained earnings 2,600,000
Total liabilities and equity $26,000,000

During 2004, the company earned net income of $3 million. It paid the required preferred
dividends of $80,000 and paid dividends to common stockholders of $750,000.

Required For each of the following independent scenarios, assume it occurred or was true
during year 2004. Explain the effect the scenario would have had on the company’s net in-
come, return on assets, and return on equity for year 2004. What effect would you expect the
event to have had on the riskiness of each type of security issued by Hard Luck Casino?
A. On January 2, 2004, the company issued $5 million of new common stock and used
the proceeds to repurchase its bonds.
(Continued)
F400 SECTION F2: Analysis and Interpretation of Financial Accounting Information
403
Analysis of Financing Activities

B. Because of new competition during 2004, the company’s profits had been $1 million
less than reported on the previous page.
C. On January 2, 2004, the company issued $8 million of new bonds to finance the pur-
chase of additional plant assets. The bonds were issued at a market rate of 10%. The
new assets produced $1.6 million of additional profits before considering the added in-
terest cost.

Analyzing Financing Decisions
C10-3
Objs. 4, 5, 6, 7 Sporty Footware, Inc. reported the following financial information at year-end 2004:



Consolidated Statements of Operations
For the Year Ended December 31,

(In thousands, except per share amounts) 2004 2003 2002
Net revenue $847,110 $661,688 $478,131
Cost of goods sold 447,524 344,884 258,419
Gross profit 399,586 316,804 219,712
Selling, general, and
administrative expenses 236,571 190,976 132,270
Income from operations 163,015 125,828 87,442
Interest expense (1,258) (761) (754)
Interest income 7,013 6,181 5,712
Income before income taxes 168,770 131,248 92,400
Provision for income taxes 55,590 44,866 30,900
Net income $113,180 $ 86,382 $ 61,500




Consolidated Balance Sheets December 31, December 31,
(In thousands, except share data) 2004 2003

Assets:
Current assets $438,284 $332,353
Property and equipment, net 160,089 121,540
Other assets 19,637 9,192
Total Assets $618,010 $463,085
Liabilities and shareholders’ equity:
Current liabilities $ 92,398 $ 61,686
Other liabilities 6,550 2,425
Long-term debt — 1,510
Shareholders’ equity* 519,062 397,464
Total liabilities and
shareholders’ equity $618,010 $463,085
*Common shares outstanding 37,557,934 37,249,529
F401
CHAPTER F10: Analysis of Financing Activities
404 Analysis of Financing Activities


Consolidated Statements of Cash Flows
For the Year Ended December 31

(In thousands) 2004 2003 2002
Cash flows from operating activities $108,049 $ 62,635 $34,227
Cash flows from investing activities $ (67,814) $(83,960) $21,520
Cash flows from financing activities
Proceeds from the exercise of
employee stock options $ 5,685 $ 3,929 $13,027
Tax benefit from exercise
of stock options 2,703 5,812 17,715
Short-term bank borrowings, net — (5,975) 5,700
Payments on long-term debt (1,510) (279) (275)
Other 30 3 12
Net cash provided by financing activities $ 6,908 $ 3,490 $36,179




Other information:
1. The company has a policy of not paying dividends.
2. Year-end stock prices were as follows:

2004 $61.50

2003 $59.13

Required Would you lend money to this firm? Would you buy its common stock? Why or
why not? Conduct whatever analysis and evaluation you believe would be helpful to answer
these questions. Support your answer by referencing your analysis.
F11 11

INVESTING ACTIVITIES
How do we account for investing activities?

L ong-term assets are necessary to support a company’s operating activities. Facilities
are needed to produce and sell products. Other long-term assets recognize the cost
of intellectual property and other legal rights controlled by a company, as well as in-
vestments and other financial resources. As a company becomes larger, it invests in more
assets and often requires more types of assets to support its business activities.

Maria, Stan, and Ellen are considering expanding Mom’s Cookie Company. They are aware
that they will need additional property and equipment for the company to produce and sell its
products to a larger market.


FOOD FOR THOUGHT
If you were advising the owners of Mom’s Cookie Company what kinds of long-term assets would you
recommend they invest in and how should they account for those various assets? Are there any tax issues
that might have an impact on the way they account for the new investments?


Stan has called a meeting with Maria and Ellen to talk about expansion plans. They begin their discussion of the assets
the company will need by considering different types of assets and how to account for them.

If we are going to produce and sell more of our products, we will need to acquire additional plant and
Stan:
equipment.
Are there other long-term assets that we will require?
Maria:
Other long-term assets may be useful. For example, we may want to protect some of our recipes and our
Ellen:
brand name with patents and trademarks. We may need to make some financial investments to provide
financial resources when we need them in the future.
Acquiring long-term assets is really just a matter of buying them and putting them to work, isn’t it? These
Stan:
activities really don’t have much effect on our profits, do they?
How we depreciate our property and equipment will have an effect on profitability and the timing of our
Ellen:
income tax payments. Other revenues and expenses can result from other activities, such as income
earned from investments in marketable securities.
Perhaps we should examine these investing activities and how they can affect our financial statements
Maria:
before we make any more decisions.
F403
CHAPTER F11: Investing Activities
406 Investing Activities


OBJECTIVES

Once you have completed this chapter, you 4 Apply appropriate measurement rules to
should be able to: the purchase, valuation, and sale of long-
term and short-term investments.
1 Identify types of long-term assets, their
purposes, and the measurement basis 5 Explain accounting issues associated with
companies use to record their assets. intangible and other long-term assets.
2 Apply appropriate measurement rules to 6 Summarize the effects of investing
the purchase, depreciation, and disposal of activities on a company’s financial
plant assets. statements.
3 Apply appropriate measurement rules to
the purchase and use of natural resources.



TYPES ASSETS
OF
Investing activities supply the resources that an organization needs to operate. Most of
OBJECTIVE 1
those resources are reported as assets, although some—for example, the value of man-
Identify types of long- agement and employee skills—are not. On its balance sheet, a company reports those
term assets, their assets for which it can reasonably identify costs and that are important to its opera-
purposes, and the tions. Exhibit 1 provides the asset section of the balance sheet Mom’s Cookie Company
measurement basis reported in its 2005 annual report. This exhibit is used as a basis for discussing the types
companies use to record
of assets most corporations report.
their assets.


Exhibit 1 December 31, 2005 2004
Balance Sheet
Assets
Presentation of Assets
Current assets:
for Mom’s Cookie
Cash $ 17,510 $ 10,680
Company
Accounts receivable 15,400 8,570
Merchandise inventory 75,920 23,600
Supplies 2,480 690
Prepaid rent 3,500 2,000
Total current assets 114,810 45,540
Long-term investments 4,000 0
Property and equipment, at cost 572,467 215,660
Accumulated depreciation (53,630) (25,500)
Property and equipment, net 518,837 190,160
Intangible assets 1,600 0
Other long-term assets 850 0
Total assets $640,097 $235,700




Most companies divide their assets into two major categories: current and long-
term. Current assets are those that management ex-
LEARNING NOTE pects to convert to cash or consume during the
coming fiscal year. Most current assets are created
In rare cases, a company’s cycle of conversion, or operating cy-

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