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Unformatted text preview: Exercise 13-1 Debt Versus Equity Assume that your client is a large company that needs $1 million to purchase additional assets for a planned expansion. Your client is considering whether to obtain the additional funds through additional debt or by issuing stock. The following data have been collected for your client: Total debt $1,000,000 Total assets $5,000,000 Interest rate on debt 10% Annual income before interest and taxes $800,000 Tax rate 40% Required: 1 What are the advantages and disadvantages of debt versus stock issuance? Advantages of debt issuance instead of stock: 1. Interest on debt is tax-deductible. Dividends that are paid on stock are not tax-deductible. 2. Bondholders do not have voting rights, so they cannot control the company as stockholders are able to do. 3. Issuing debt does not decrease EPS. 4. There is no risk from changes in market value of the stock. Disadvantages of debt issuance instead of stock: 1. Issuing stock may make current owners lose control of the company. 2. Issuing debt increases the debt-to-equity ratio. 3. Debt increases default risk and also has interest-rate risk. 4. Bondholders may place loan covenant restrictions on the company. 2 How would debt issuance affect the debt-to-equity ratio? Calculate the ratio before and after the debt is issued. What other ratios or financial measures would be affected? Issuing debt increases the debt-to-equity ratio. Debt-to-Equity Ratio = Total Debt ÷ Total Assets Before: $1,000,000 ÷ $5,000,000 = 20.0% After: $2,000,000 ÷ $6,000,000 = 33.3% The company would be considered to have a higher level of leverage, making it appear more risky, if more debt is issued. The company’s return on assets would be likely to decrease, since interest is an expense that lowers income. However, issuing debt would also cause assets to increase. Return on stockholders’ equity would decrease because of interest expense. 3 Your client has considered issuing debt that carries a provision allowing the lenders to convert their holding to stock at a future time. Should such an instrument be considered to be debt or stock? Write a memo to advise your client on the proper accounting for this instrument. Date: Current date To: Mr. Client From: Student Re: Debt with conversion features Convertible debt is considered a liability since its issuance causes the company’s debt to rise. The entire debt amount is an obligation of the company, and no ownership rights are conveyed until the debt is converted. Only at conversion will an equity feature be recognized. If you have additional questions, feel free to call my office at 515-555-1212. 4 Your client has considere issuing stock that pays interest based on the company's level of income. For example, if earnings were above a certain percentage, interest would be paid at 10 percent. But if the client's earnings were lower, the interest rate on the stock would be lowered also. Should such an instrument be considered to be debt or stock? Write a memolowered also....
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- Spring '09
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