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Chapter 11 - Solution Manual

The debt to equity ratio would be higher it would

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The debt to equity ratio would be higher. It would approach the debt covenant restriction and investors may perceive the company to be a risky investment. Upon conversion, there would be no cash flow. The debt would be replaced by stock (equity securities) and the debt to equity ratio would improve. The company would have the alternative of recording conversion at book value or at fair value. If the fair value method is selected there would be an income statement gain or loss. The effect on preexisting stockholders would be that the after tax interest cash flows would be replaced by and may not be equal to dividend cash flows. However, unlike the redeemable preferred stock, the company would be able to retain its capital without resorting to alternative or new sources of financing. If redeemable preferred stock is issued, it would be recorded at its issue price. Under GAAP, the preferred stock would be debt and would appear on the balance sheet. The debt to equity ratio would be higher. It would approach the debt covenant restriction and investors may perceive the company to be a risky investment. The preferred stock dividend payments would equal the interest payments that would have been made to the holders of the convertible debt, but the dividends would not provide a tax shield. Redemption would require a cash outflow, but would have no income statement effect. d. The change from reporting the conversion feature as debt to equity would shift balance sheet numbers from debt to equity, thereby enhancing the debt to equity ratio for the convertible debt option and alleviating the constraint on debt covenant restrictions. However, management decisions should be based on economic consequences of alternatives. Managerial action should not be motivated merely by accounting representations. Whether the "equity feature" is reported as debt or equity will, in and of itself, have no cash flow effects and should therefore not affect management's decision. Hence, if the debt covenant restrictions are not a factor, management's decision to issue convertible debt versus redeemable preferred stock should not be affected. However, there is documented evidence is that consistent with the argument that management's decisions are affected by financial statement appearances. The decision to select one alternative over another may be affected by the debt covenant restrictions. If the classification of the "equity feature" materially affects the debt to equity ratio, then management may be more prone to select convertible debt because the debt provides a tax shield and no cash flow will be required to convert the debt to equity. Case 11-4
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218 a. The effective interest method of amortization of bond discount or premium applies a constant interest rate to the carrying value of debt as opposed to the straight-line method that applies a constant dollar amount over the life of the debt resulting in a changing effective rate paid based on the carrying value of the debt. Either method, however, computes the premium or discount to
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