Chapter 12 - Solution Manual

Chapter 12 - Solution Manual - separated and treated...

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254 separated and treated differently by the investor. It is an either or situation, the issuer has either a debt security or equity securities, never both. Another argument for treating convertible debt as straight-debt lies in the notion that it should be classified according to its governing characteristic. In other words, we ask whether the debt instrument satisfies the definition of a liability or equity at its issuance. At issuance, the company has an obligation to pay the principle and interest until conversion takes place. Thus, the contractual terms of convertible debt indicate that it is a liability. Secondly, the convertible debt instrument embodies an obligation to transfer financial instruments (the stock) to the holder, if and when the option to convert is exercised. Thirdly, we should classify in accordance with the fundamental financial instrument that has the higher value. At issuance, the debt component has a higher market value than the option to convert. WWW Case 11-11 The solution to this case is dependent upon the companies selected by the students. A recommended method to check their solutions is to require the downloaded company information to be turned in along with the solution. Financial Analysis Case Answers will vary depending on the company selected. CHAPTER 12 Case 12-1 There is insufficient information to calculate the amount of depreciation that would be deducted from the $200,000 pretax accounting income if the purchase were made; hence, the solution will ignore it and concentrate only on the deferred tax impacts. a. The projected amount of income tax expense that would be recognized if Whitley waits until next year to purchase the equipment is calculated as follows: Pretax accounting income $200,000 Reversal of deductible amount (37,500) Reversal of taxable amount 42,500 Taxable income $205,000 Tax rate x 40% Taxes payable $ 82,000 Decrease in deferred tax asset 15,000 Decrease in deferred tax liability (17,000) (42,500 x 40%) Income tax expense $ 80,000
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255 b. The projected amount of income tax expense that would be recognized if Whitley purchases the equipment in 2010 is calculated as follows: Income tax expense, calculated in a. $ 80,000 Increase in deferred tax liability (50,000 x 40%) 20,000 Income tax expense $100,000 c. If the goal of management is to improve the appearance of their financial statements, the purchase should be postponed. The following financial statement effects would occur if the purchase were made in 2010. Current assets (cash) would decrease by the amount of the purchase price. Long term assets would increase by the same amount less depreciation. Current liabilities would be unaffected. The result would be a decline in liquidity measures, such as the current ratio and working capital. The deferred tax increase would increase long-term liabilities. At the same time net income would decrease by the amount of depreciation expense and by the amount of the deferred tax liability increase. The effect would be to increase the debt to equity ratio.
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