# ch10 - Chapter 10 Solutions Overview Problem Length{S{M...

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Chapter 10 - Solutions Overview: Problem Length Problem #s {S} 1 - 2, 6 - 22, and 25 {M} 3 - 5, and 23 - 24 1.{S}a. When full-coupon debt is issued, interest paid reduces cash from operations (CFO). When zero-coupon debt is issued, however, no cash interest is paid. CFO is unaffected, and is therefore higher than when full- coupon debt is issued. In addition, when imputed interest on zero-coupon debt is tax deductible, CFO is further increased by the tax benefit. b. When full-coupon debt is issued, the proceeds are included in cash from financing (CFF). When that debt matures, the amount paid reduces CFF. Assuming the debt is issued and redeemed at par, the net effect on CFF is zero over the life of the debt. Zero-coupon debt is issued at a discount; CFF is below the full-coupon case. However at maturity the full face amount is paid (same as full-coupon case). The net amount of CFF (outflow) is therefore greater than when full-coupon debt is issued. c. No effect. d. Interest on the zero-coupon bond rises each year as the carrying amount rises, increasing the base on which each year’s interest expense is computed. All other things being equal, net income declines each year. 2.{S}(i) Net income declines as interest expense increases, reflecting the higher level of interest rates. (ii) The market value of the firm’s debt should remain unchanged. As the interest rate adjusts to changes in market rates, investors will pay the face amount for the debt, assuming no change in credit risk. 10-1

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3.{M}a. Reported data AMR Corp US Airways 1998 1999 1998 1999 Cash and short-term investments \$ 2,073 \$ 1,791 \$ 1,210 \$ 870 Net receivables 1,543 1,134 355 387 Inventories 596 708 228 226 Other current assets 663 791 571 613 Current assets \$ 4,875 \$ 4,424 \$ 2,364 \$ 2,096 Accounts payable 1,152 1,115 430 474 Accrued liabilities 2,122 1,956 1,016 1,276 Air traffic liability 2,163 2,255 752 635 Notes payable and current portion LT debt 202 538 71 116 Current liabilities \$ 5,639 \$ 5,864 \$ 2,269 \$ 2,501 Net working capital (764 ) (1,440 ) 95 (405) Current ratio 0.86 0.75 1.04 0.84 Quick ratio 0.64 0.50 0.69 0.50 Cash ratio 0.37 0.31 0.53 0.35 b. Unlike other payables, the air traffic liability will not require cash outlays (other than low marginal costs); instead this obligation is satisfied as customers use their tickets on flights. The air traffic liability should therefore be excluded from computations of short-term liabilities. 10-2
c. Adjusted data AMR Corp US Airways 1998 1999 1998 1999 Current liabilities (reported) \$5,639 \$5,864 \$2,269 \$2,501 Air traffic liability (2,163) (2,255) (752) (635) Current liabilities (adjusted) \$3,476 \$3,609 \$1,517 \$1,866 Net working capital (adjusted) 1,399 815 847 230 Current ratio 1.40 1.23 1.56 1.12 Quick ratio 1.04 0.81 1.03 0.67 Cash ratio 0.60 0.50 0.80 0.47 As expected, all of American Airlines' liquidity measures improve when the air traffic liability is removed from current liabilities. However the adjustments in the table above overstate the firms’ liquidity, especially for AMR. A portion of the air traffic liability relates to frequent flyer programs (37% of AMR’s 1999 liability and 13% of US Airways’ 1999 liability). AMR’s frequent flyer obligation is based on the incremental costs of fuel, food, and reservations/ticketing costs (US Airways’ approach is similar but includes insurance and other compensation). Thus some portion of the air traffic

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## This note was uploaded on 04/15/2009 for the course ACCOUNTING BUSI0027 taught by Professor Guan during the Spring '09 term at HKU.

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ch10 - Chapter 10 Solutions Overview Problem Length{S{M...

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