C on the financial statementsanycompanyretiringdebt

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Unformatted text preview: debt at $3,505 million, the covenant limits additional debt to no more than $1,307 million. b. The creditors are trying to control the amount of debt that J.C. Penney has on its balance sheet by limiting that debt to a multiple of annual cash flow. The thinking is that the debt will be repaid from that cash flow, so a reasonable limit on debt would be one that correlates the amount of debt with the amount of cash flow the company generates. If the company wants to borrow more, it needs to generate more cash flow; if the company (due to a recession or to poor operations) generates less cash flow, then it will be allowed to borrow less. c. If J.C. Penney violates the financial covenant, the creditors have the right to immediately call the loans, requiring the company to pay them off at once. Most likely, however, would be a renegotiation of the credit agreements between the creditors and the company. Contract issues such as interest rates, fees, and future financial covenants might be changed by the lenders who would feel that they are carrying more risk due to the covenant violation. ID11–10 a. On the financial statements a capital lease (a lease that is “equivalent to purchasing an asset”) is treated like the company had purchased the fixed asset. The asset and the related liability are recorded on the balance sheet and interest and depreciation are recorded on the income statement. An operating lease (a lease in the nature of short­term hire) is treated like a recurring expense each month but nothing is recorded on the balance sheet. The amount of the lease payment is shown as an expense each month. The result is that a company with an operating lease will show higher net income (in early years) and a lower debt/equity ratio than a company with a capital lease. b. The rule passed in 1981 was unpopular for 2 primary reasons. The first was that it forced companies to capitalize some leases. This would have the impacts as described above. Capitalized leases would tend to lower net income and increase the debt/equity ratio. The second reason it was unpopular was because it was a relatively complex set of rules that had to be followed. These rules required a fair amount...
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