Both companies saw their adjusted debt ratio increase

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: is greater than the balance sheet amount of $293 million. ID11–5 a. For the market value of the liability to increase so dramatically, market interest rates would have had to fall substantially. b. Loss on long term debt 1,400 Long term debt 1,400 c. Loss on retirement of debt 1,400 Long term debt 8,300 Cash 9,700 d. a. b. Carrying the debt at fair market value would require the company to book the $1.4 billion loss, even if the debt were not retired at that market price. On the other hand, carrying the debt at book value using the effective interest rate method would show the $1.4 billion loss only if the debt were retired at current market prices. If the debt were not retired, the loss would not be recorded. ID11–6 A large amount of debt forces a company's management to place greater emphasis on generating cash so that it has sufficient cash to make the required interest and principal payments. Thus, a company may alter its operating, investing, and financing decisions to allow it to generate the cash it needs when it needs it. The massive borrowing activity during the 1980s would have manifested itself as increased liabilities on the companies' balance sheets. By analyzing different companies' current ratios and debt/equity ratios, which are measures of a company's solvency, potential investors may have been able to identify those companies that were taking on an excessive amount of debt. However, even this type of analysis may not have been sufficient to identify overly risky companies. Companies will often engage in off­balance sheet financing, such as structuring leasing arrangements as an operating lease. Companies are most likely to engage in off­balance sheet financing when they are close to violating existing debt covenants that specify a maximum debt/equity ratio or when the company already has a large amount of debt. Since, by definition, off­balance sheet financing does not show up on the balance sheet as a liability, it will not be reflected in either the current ratio or the debt/equity ratio. An alternative analysis strategy investors could have used was to examine the statement of c...
View Full Document

{[ snackBarMessage ]}

Ask a homework question - tutors are online