11 Chapter Solutions
1.{S}(i) Interest expense = 12% x $10,000 (beginning balance of lease obligation) = $1,200. -
(ii) The lease obligation will be reduced by $100 ($1,300 $1,200) leaving an obligation of $9,900.
(iii) Cash from Operations will be reduced by the interest payment of $1,200. Cash from investing activities will not be affected. (However, the firm will report the capital lease as a noncash investment and financing activity. Cash from financing will be reduced by the amount of the principal payment of $100. (iv) Under an operating lease there is no lease obligation on the balance sheet. The only effect on income is Rent Expense of $1,300. Similarly, CFO is reduced by $1,300. (CFI and CFF are not affected). 2.{S}(i) In a take-or-pay arrangement, a company contracts to buy or pay for a certain amount of a suppliers commodity at a predetermined price over a stated time period. The company, by entering the contract, incurs an economic liability. However, since it is only a contract, no accounting liability is recorded on the balance sheet it is off balance sheet.
(ii) In a sale of receivable, a company sells its receivables to a third-party, usually a financial institution. Typically, the sale is made at a discounted price from the face value and the seller may retain some or all of the default risk. The sale, in substance, is a financing arrangement with the receivables being used as collateral. However, under GAAP, the transaction is treated as a sale and the debt does not appear on the balance sheet. (iii)A joint venture represents an investment of 50% or less by one company (the investor) in another company. Under GAAP, since ownership is not over 50%, the assets and liabilities of the joint venture need not be consolidated with the parents assets and liabilities. Hence, any debt taken on by the joint venture remains off balance sheet even when the investor is liable for the debt.
3.{S} Effect of choice of interest rate on lessee: 9% versus 10% First Lease
11-1
Year (i) (ii) Interest expense: Lower interest rate reduces interest expense. Amortization expense: Lower interest rate increases present value of minimum lease payments, creating higher asset amount to be amortized over lease term. Total lease expense: T he net effect for the first year depends on the lease amounts; over the lease term, however, total expense equals total lease payments regardless of the choice of interest rate. Cash from operations: Lower interest rate shifts expense from interest to amortization (see i and ii); as cash from operations is decreased only by interest expense, a decrease in interest expense increases CFO, both in the first year and over the leas term. Average assets: Lower interest rate increases present value (see ii) resulting in higher average assets, both in first year and over lease term. Average liabilities: Lower interest rate increases present value recognized as liability, both in first year and over lease term. Lower Higher
Term Lower Higher
(iii)
Indeter minate
Equal
(iv)
Higher
Higher
(v)
Higher
Higher
(vi)
Higher
Higher
4.{S}a.
Pallavi must capitalize the lease because the lease agreement contains a bargain purchase option. Note that the lease also meets one other capitalization criterion: The present value of minimum lease payments exceeds 90% of the fair market value of the equipment (see part b for computations). The fair market value of the asset is $125,000. The present value of the MLPs is $127,785 (at 8%, the lower of the lessee and lessor rates); the asset must be capitalized at the (lower) fair market value. (Note that the lease obligation is the sum of the present values of the MLPs and the bargain purchase option the latter is not provided.) Leases must be capitalized at the lesser of the present value of lease payments or the fair value of the lease; in this case, the lease must be capitalized at the fair value of $125,000. The existence of the bargain purchase option requires
b.
c.
d.
11-2
depreciation over the estimated economic life of the asset rather than the (shorter) lease term. e. The option creates the presumption that the asset will be held past the expiration date of the lease. Otherwise it must be assumed that use of the asset will revert to the lessor at expiration, requiring the lessee to depreciate the leased asset over the (shorter) lease term.
5.{M}a.
The following states the effects of Tolrem using the capital lease method as compared with the operating lease method. (i) Cash from operations is higher as only the interest portion of lease expense is deducted from operating cash flows; total lease expense is deducted for operating leases. (ii) Financing cash flow is lower for capital lease, as part of lease rental is treated as amortization of liability and classified as financing cash outflow. (iii)Investing cash flow is not affected by the lease treatment. However, the firm will report capital leases in the statement of cash flows (or a footnote) as noncash investment activities. (iv) Net cash flow reflects the actual rental payment and is unaffected by the financial reporting treatment of the lease. (v) Debt/equity ratio is higher for capital lease, as it records the present value of minimum lease payments as debt and reduces net income (and therefore equity) in first year. (vi) Interest coverage ratio is usually (not always) lower for capital lease method, which reports interest expense but also higher EBIT, see (vii). For coverage ratios well above 1.0, the ratio will decline. If the increase in interest expense exceeds the increase in EBIT, the ratio will decline even for firms with very low coverage ratios. (vii)Operating income is lower for operating lease because the total lease payment is an operating expense; for capital lease, interest portion of lease expense is nonoperating. (viii)Net income is higher for operating lease; total lease expense (interest plus depreciation) is higher for capital lease. (ix) Deferred tax assets are higher for capital lease; as lease treatment for tax purposes is unaffected by
11-3
accounting choice, capital lease will generate a deferred tax asset as taxable income (operating lease) exceeds pretax income (capital lease). (x) Taxes paid are unaffected by choice of method. (xi) Pretax return on assets is higher for operating leases as pretax income is higher and no assets are reported as the result of the lease; a capital lease reduces income and reports lease assets. Post-tax return on assets is higher for the same reasons. (xii)Pretax return on equity: both pretax income and equity are higher for operating than for capital leases. The higher pretax income should increase the ratio in all but exceptional cases. Post-tax return on equity should be higher for same reason. However as increase in post-tax income equals (for first year) increase in equity, there may be more exceptional cases. b. Net income (viii) will be lower for the operating lease after the "crossover" point. As total net income over the life of the lease is unaffected by the accounting choice, higher net income (operating lease) in the early years must be offset by lower net income in later years. Consistent use of the operating lease method in place of capitalization will not change the direction of the effects shown in part A, but will increase their magnitude. In aggregate, new leases will keep Tolrem from reaching the crossover point for net income, keeping net income and return ratios higher than if the leases were capitalized.
c.
6.{L}a. and b. Caramino Operating income Depreciation expense1 Lease rental expense EBIT Interest expense2 Earnings before tax Income tax expense Net income
1
Aglianico $ 20,000 (10,000) $ 10,000 10,000 (4,000) $ 6,000
Difference $ None (8,624) 10,000 $ 1,376 (2,650) $ (1,274) 510 $ (764)
$ 20,000 (8,624) 11,376 (2,650) $ 8,726 (3,490) $ 5,236
2
The present value of the minimum lease payments is $43,121 ($10,000 + 4 payment annuity of $10,000 per year at 8%). Assuming zero residual value, depreciation = $43,121/5 = $8,624. Interest expense = 8% x ($43,121 - $10,000) = $2,650
11-4
Caramino's EBIT is $1,376 higher; Aglianico reports rental expense but no depreciation expense since it does not record an asset. Because total lease expense (depreciation plus interest) is higher than the lease rental, Caramino's EBT is lower by $1,274. After a deferred income tax offset of $510, Caramino's net income is $764 lower. Caramino's deferred tax debit (asset) results from the difference between financial reporting (capital lease) and tax reporting (operating lease). The $1,274 timing difference results in a deferred tax debit of $1,274 x .40 = $510 c. and d. Comparison of Cash Flow Statements Caramino Net income Addback: Depreciation expense Other adjustments: Deferred taxes Interest payable Cash from operations Investment cash flow Financing cash flow Net cash flow Note: $ 5,236 Aglianico $ 6,000 Difference $ (764) 8,624 7,860
8,624 $ 13,860 (510) 2,650 $ 16,000 -0(10,000) $ 6,000
$
6,000
$
$
6,000 -0-0$ 6,000
(510) 2,650 $ 10,000 -0(10,000) $ -0-
We assume that all revenues generated by the firm have been collected by the end of the year. Caramino reports higher cash from operations by $10,000. Since the tax rate is 40%, Aglianico (operating lease firm) reports aftertax operating cash outflow of $6,000. Caramino (capital lease firm) pays no interest but, since it uses the operating lease method for taxes, receives a tax deduction of $4,000 for the annual payment of $10,000. Caramino's aftertax operating cash inflow is $4,000. The difference ($6,000 + $4,000 = $10,000) is recorded by Caramino as a financing cash outflow; this is the amount of the lease payment considered a reduction of the capitalized lease liability for 2002. [Note that the lease payment made on January 1, 2002 has no interest component; there is no accrued interest as the lease has just begun. Interest accrued during the year will be paid January 1, 2003.]
11-5
e.
There is no impact on investing cash flow for either firm. Caramino would report the present value of the capital lease as a noncash investment activity. The net cash outflow for each firm is the lease payment of $10,000 less the tax deduction of $4,000 (40% tax rate). Only the classification of cash flow components is affected by the lease method used. By using the capital lease method, Caramino reports higher debt and lower income. However the firm also reports higher cash from operations. The choice of method may reflect different debt covenants or simply a preference among financial characteristics.
f.
g.
7.(M) a.
Since it is the first year: Capital lease obligations $2,596,031 Repayment of capital lease obligations 3,969 Capital lease at inception $2,600,000 Amortization expense = $2,600,000 - $2,479,570 = $120,430 Assuming the asset is being amortized on a straight line basis over the lease term, the lease term = $2,600,000/$120,430 = 21.6 or 22 years Total expense = interest + amortization = $120,430 + $223,733 = $344,163
b.
c.
CFO was reduced by the interest expense of $223,733 and CFF was reduced by the repayment of capital lease obligations of $ 3,969 Free cash flows should be reduced by $2,600,000 the cost of the leased asset. (i) Lease expense would be lease payment = $223,733 + $3,969 = $227,702
d.
e.
(ii) CFO would be reduced by lease payment of $227,702 f. Using 1999 payment only: $223,733/$2,600,000 = 8.6% Using all the payments, we have exact MLPs for the six years 1999 2004. The thereafter MLPs totaling $4,596 thousand are spread over 16 years; i.e. $287.25 thousand/year. Equating this stream to the present value of $2,600,000 yields a rate (IRR) of 9.3%.
11-6
The two methods yield rates within range of each other especially when we consider that the rate derived from the first method is typically downward biased.
8.{M}a.
The adjustment involves the addition of the interest component of minimum lease payments to stated interest expense. The adjustment reflects a partial, de facto capitalization of operating leases. (i) Unadjusted Ratio of Earnings to Fixed Charges: $ 2,363,646 68,528 $ 2,432,174 $ 68,528 35.5X
Pretax earnings Interest on indebtedness Earnings before interest and taxes (EBIT) Fixed Charges: Interest on indebtedness Unadjusted Ratio of Earnings to Fixed Charges
(ii) The unadjusted ratio is almost four times the adjusted ratio. Note: the SEC rule that governs this calculation assumes that the interest component is one-third of the MLP. The true interest component may be higher or lower, changing the coverage ratio. b. c. Reported debt-to-equity = $550,000/$2,233,303 = 0.25 Calculation of amounts adjusted for lease capitalization: The Limited, Inc. 1999 Working Capital Position and Capitalization Table Reported $1,070,249 Adjusted 633,5791
(i) Working capital Capitalization: Long-term debt Add: Capitalized lease payments (ii)Adjusted long-term debt Shareholders' equity Total capitalization (iii) Debt-to-equity
1
$
550,000
2,233,303 $2,783,303 0.25
550,000 3,452,6282 $4,002,628 2,233,303 $6,235,931 1.80
of the 2000 MLPs
Working capital calculated as
is
reduced
by
the
principal
component
$436,670 = [($643,828 - (.06 x $3,452,628)], where $3,452,628 is the present value calculated in note 2 below.
11-7
2
Present value of MLPs using an interest rate of 6%. The thereafter MLPs are spread using the constant rate assumption; ($502,880 in 2005 and 2006 and $422,102 in 2007).
9.{S} Note: all amounts in $millions a. Debt to equity = ($2,416 + $235)/$4,448 = 0.60 b. (i) Interest portion of 2001 payment = $63-$39 = $24 Therefore interest rate = $24/$235 = 10.2% rate assumption 2005 $32 yields 2007 $ 8 the
(ii) Using the constant following stream: YEAR MLP 2001 $63 2002 $57 $57
2003
2004 $48
2006 $32
The IRR that equates the above to $235 is 7.9% c. Under the constant rate assumption, the payment stream to be discounted at 10.2% is YEAR MLP 2001 $1,020 2002 $1,030 2003 $1,040 2004 $1,020 2005 - 2014 $980 2015 $620
The present value is $7,435 d. Adjusted debt-to-equity is ($2,416 + $235 + $7,435)/$4,448 = 2.27 The adjustment increases the ratio almost four-fold. The real effect is greater as equity would be lower if Delta had capitalized its operating leases at their inception. After adjustment, both AMRs and Deltas ratios are at similar levels of 2.3x. Debt-to-equity ratio Reported data Adjusted for operating leases AMR 0.9 2.3 Delta 0.6 2.3
e.
Had the lower rate been used, the present value of Deltas operating lease would be significantly higher as would its debt-to-equity ratio. f. The adjustments are appropriate for two reasons (1) To obtain the appropriate levels of the ratio for each firm. For both companies, the reported ratios understate their financial leverage. (2) For comparison purposes. Before adjustment, Deltas ratio at 0.6x is 50% lower than AMRs 0.9x. After
11-8
10.{M}a.
adjustment, that superiority is removed as both firms have similar ratios. The following MLP stream is assumed ( million): YEAR MLP 1 166.5 2-4 68.8 5-7 68.8 8 5.8
At a rate of 7%, the present value is 505.3 million b. (i) 1,294/14,145 = 0.09
(ii)(1,294 + 505)/14,145 = 0.13 c. Another assumption would be to find a decline rate from the initial payment of 166.5 such that the sum of the years 2 to 5 payments using that decline rate equals 275.2; i.e. solve for d in the following equation (d + d2 + d3 + d4 ) x 166.5 = 275.2 The above can be solved by trial and error and the solution is d = 67.66% with a MLP stream of 112.6, 76.2, 51.5 and 34.9. Using this MLP stream would increase the present value of the operating lease obligation. 11.{S}a. We use the constant rate assumption, following payment stream ( millions) YEAR Payments 2000 1,718 2001 1,740 2002 1,433 2003 1,292 yielding the
2004-2012 1,370
2013 1,168
At a discount rate of 7%, the present value is 12,543. b. (i) Reported debt-to-equity = 1,294/14,145 = 0.09 Adjusted for part a: (1,294 + 12,543)/14,145 = 0.98
(ii) Adjusting for operating leases as well (1,294 + 12,543 + 505)/14,145 = 1.01
12.{S}a.
The cash outflow of $25.6 million represents the decrease in the balance of sold but uncollected receivables ($192.8 - $167.2). It represents net collections (by Arkla the as firm continues to service the receivables) of receivables sold; amounts collected from previously sold receivables
11-9
were paid to the purchasers of those receivables. b. Receivables sold but uncollected as of 12/31/93 can be deduced to be: Outstanding 3/31/94 Decrease during quarter Outstanding 12/31/93 c. The required ended: Cash outflow adjustments to $118.7 million 107.7 $226.4 million Arkla's CFO for quarters
March 31, 1994 $107.7
March 31, 1995 $25.6
These amounts are the decrease in receivables sold during the respective quarters. The adjustment is required because the cash flow was recognized when the receivables were sold rather than when customers paid. This adjustment produces a measure of CFO based on when the receivables were collected. 13.{S} a. All amounts in $millions (i) Current ratio was increased by 15% from 1.61 to 1.86 as a result of receivable sale. Reported = $686/$369 = 1.86 Adjusted = ($686 + $153.1)/($369 + $153.1) = 1.61 (ii) & (iii) Average receivables as reported = .5($546 + $312) = $429 Adjusting for sale of receivables would increase average receivables by .5($153.1 + $115) = $134 to $563 Reported turnover = $2,951/$429 = 6.88 # of days = 365/6.88 = 53 days
Adjusted turnover = $2,951/$563 = 5.24 # of days = 365/5.24 = 70 days As a result of the receivable sale the cash cycle looked better than it really was by (70 53) = 17 days and the receivables turnover improved from 5.24 to 6.88 Reported debt/equity = $1,096/$950 = 1.15 Debt should be adjusted upwards by the receivables sold to ($1,096 + $153.1 =) $1,249.1 with a resultant debt to equity ratio of $1,249.1/$950 = 1.31. Reported cash flow from operations increased by $154 million from ($96) million to $58 million. These amounts
b.
c.
11-10
were inflated by the increase in receivables sold and should be adjusted by that increase: Adjusted CFO 1998 = ($96) ($115 $103.3) = ($107.7) Adjusted CFO 1999 = $58 - ($153.1 $115) = $19.9 After removing the effects of the receivable sales, CFO increased by $127.6 million from ($107.7) million to $19.9 million. The actual level and trend in CFO is considerably lower than the amounts reported.
14.{M}a.
All amounts in $ millions 1997 Receivables reported Receivables sold Adjusted receivables Average receivables as reported adjusted Sales Receivable turnover Reported Adjusted # of days receivable Reported Adjusted Cash cycle effect 692.0 711.2 $4,537.0 6.56 6.38 56 days 57 days 1 day 729.5 773.7 $3,867.0 5.30 5.00 69 days 73 days 4 days $ $ 664.0 664.0 $ $ 1998 720.0 38.4 758.4 $ $ 1999 739.0 50.0 789.0
11-11
The sale of receivables allowed the company to show an improved receivable turnover and cash cycle; the improvement was more significant for 1999 as the amount of receivables sold increased and sales declined. b. The effect on the current ratio is minimal as the same amount is added to both numerator and denominator of the ratio and that ratio is close to 1. The debt-to-equity ratio adjustment is more significant in 1999 due to the increase in receivables sold and the lower equity amount. 1998 Current assets Current liabilities Current ratio Adjusted (add receivables sold) Current assets Current liabilities Current ratio adjusted Debt reported Debt adjusted Equity Debt-to-equity reported Debt-to-equity adjusted c. $ $ 1,711.4 1,530.4 1.118 963.0 1,001.4 572.0 1.68 1.75 $ $ 1,665.0 1,522.0 1.094 961.0 1,011.0 376.0 2.56 2.69 $ 1,673.0 1,492.0 1.121 1999 $ 1,615.0 1,472.0 1.097
As the calculation below indicates, both the level and trend in CFO are overstated as a result of the sale of receivables. 1997 CFO as reported Change in receivables sold CFO adjusted $(113.0) --$(113.0) 1998 $ (59.0) 38.4 $ (97.4) $ 1999 (6.0) 11.6 $ (17.6)
11-12
15.{S}a.
The cash from investment amounts are equivalent to the change in the Receivables sold by Funding to purchaser. (Recall that 1997 was the first year of receivable sales.) RECEIVABLES Reported Add: Receivables sold by Funding to purchaser Adjusted 1997 $ 174.0 37.0 $ 211.0 1998 $ 169.7 36.8 $ 206.5 1999 $ 154.1 41.8 $ 195.9
b.
Percentage decline -17.5% -17.8% -21.3% The sale of receivables allowed the company to show receivable balances 17% to 21% less than their actual levels. c. The sale of receivables should be reported as cash from financing as they are, in effect, borrowings (using receivables as collateral). Aluminum producers that have take-or-pay contracts for energy and/or bauxite have converted significant variable costs into fixed costs. Therefore, their marginal costs are much lower than if these contracts had not been entered into. Under these conditions, aluminum producers will continue production as long as revenue exceeds marginal costs, even though they lose money based on total costs.
16.{S}
17.{M}a.
By transferring receivables to a (unconsolidated) subsidiary, Lucent removed the receivables from its receivable balance and reported them as Investments, a somewhat different asset category. Analytical adjustment is required to eliminate the artificial reported improvements in receivables turnover, the current ratio and the cash cycle. The adjustment requires adding $700 million (in addition to the balance of uncollected receivables) to the 1999 accounts receivable and current assets. The effect is to increase the growth in receivables, reduce the receivable turnover and increase the number of days receivables outstanding. This adjustment reinforces the conclusion (see text page 381) that Lucents receivables growth outpaced the growth in sales. On the other hand, the adjustment improves the 1999 current ratio. REPORTED ADJUSTED
b.
11-13
1998 Balance of uncollected receivables Receivables transferred to QSPE
1999
2000
1999
2000
$
0
$
625 $ 1,329
700 Adjustment: Add $1,325 $1,329
Accounts receivable Current assets Current liabilities Sales Selected Trends and Ratios % Change in sales from 1998 % Change in A/R from 1998 # of days A/R outstanding Current ratio
7,821
9,097 19,240 9,150 30,617
10,059 21,490 10,877 33,813
10,422 20,565 9,775
11,388 22,819 12,206
24,367
26% 16% 117 1.45 101 2.10
39% 26% 103 1.98
26% 33% (24%)
39% 46%
109 (105) 117 (114) 2.10(2.03) 1.87
Note: The bold values indicate which amounts were altered from Exhibit 11-4. The Exhibit 11-4 amounts for those items affected by the adjustment are shown in parentheses.
18.{M}a.
Debt should be increased by: $ 20 million (present value of operating lease) 5 (guarantee) 7 (present value of take-or-pay agreement) $ 32 million There is no effect on equity as each obligation is offset by a corresponding asset: Leased assets for operating lease Receivable for Crockett's obligation to repay debt Supply agreement The recomputed debt-to-equity ratio is: ($12 + $32)/$20 = 2.2X as compared
to
.6X
before
11-14
adjustment b. Additional interest expense is: Lease (effective interest rate is about 18%) .18 x $20 = $3.6 million Bond guarantee .10 x 5 = 0.5 Total $ 4.1 million Before adjustment, the interest expense is $1.0 million and the times interest earned ratio is 5.0, implying EBIT of $5.0 million. After adjustment, the ratio is: ($5.0 + $4.1)/($1.0 + $4.1) = 1.78X No adjustment has been made for the take-or-pay contract, as it does not affect 1993 interest expense. Adjustments in future years will be based on the implicit interest rate of 21%. c. Reasons for entering into off-balance-sheet obligations: 1. 2. 3. 4. Avoidance of or mitigation of the risk of violating debt covenant restrictions. Leased assets revert to lessor after eight years, limiting risk of obsolescence. Guarantee of Crockett's debt may lower interest costs, increasing profitability of investment. Contract with PEPE secures source of supply and possibly advantageous pricing.
d.
Additional information needed for full evaluation: 1. (Lease) Useful life of leased assets; conditions under which lease can be canceled; nature of leased assets. (Guarantee) Financial condition of Crockett; bond covenants. (Take-or-pay) Alternate sources of supply; quantity to be purchased relative to total needs; price provisions of contract.
2. 3.
22.{S} The adjusted ratios are poorer than those based on Sears reported data. The adjustment for securitization of receivables accounts for far more of the impact than the operating leases.
11-15
REPORTED (i) Current assets Current liabilities Current ratio $28,667 13,701 2.09 $18,038 6,839 2.64
ADJUSTMENTS $6,579 $6,579 + $194
ADJUSTED $35,246 20,474 1.72 $25,992 6,839 3.80
(ii) Debt Equity Debt-to-equity ratio
$6,579+$1,375
Note: See problems 11-19, 11-20, and 11-21 for explanation of these adjustments
23.{M}a.
Using the constant rate assumption (MLPs of $59 million from 2004 - 2017 and $8 million in 2018), the implicit interest rate is 4.19%. Note that Texaco has not guaranteed all of this lease. The total present value of the guaranteed portion of the lease is approximately ($336/44%) $764 million.
b.
The rate is somewhat lower than the 5% - 5.5% calculated for Texaco in the chapter (page 385).
rate
c.
Equilon may have less debt (in relation to their assets) than Texaco, or the nature of its business (or of the leased assets) may be operationally less risky. The leases may have been entered into when interest rates were especially low.
24.{M} (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) (x) (xi) (xii) Assets Revenues Expenses Asset turnover ratio Interest income Cost of goods sold Net income Retained earnings Taxes paid Post-tax ROA Cash from operations Investment cash flow 1st Year Higher Higher Higher Higher Higher Higher Higher Higher No effect Higher Higher Lower 9th Year Higher Lower Lower Lower Higher No effect Lower Higher No effect Lower Lower Higher
11-16
Assets are higher because inventory is replac...