Chapter 11 - Solution Manual

Team 2 against separation present arguments against

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This makes the debt look like it was issued at a more favorable interest rate than it actually was. Team 2: Against Separation. Present arguments against the separation of the debt and equity features of convertible debt. According to APB Opinion No. 14 , convertible debt should be reported in the balance sheet as straight- debt. We agree that the convertible debt is issued at a higher price than straight-debt is, but any value added due to the ability of the investor to convert the debt to equity shares is not separable from the debt. There is either debt of equity outstanding at any one time, not two different securities. Until conversion takes place, there is only debt outstanding. After conversion takes place, there is only equity outstanding. Convertible debt is not like debt that is issued with warrants. The warrants are separate securities. They can be sold or exercised. If the investor sells the warrants, the debt is still outstanding. If the investor exercises the right to purchase shares of stock, the debt is still outstanding. The debt and the warrants are clearly two separate securities. Conversely, the convertible debt is not two securities that can be
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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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