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Dear Tutors,


I asked this case before. Please find the answer below.

Please help

me understand the two financing alternatives using the numbers in the below case. Also, how to calculate and convert from convertible bonds to common stocks?


Case 11-3 Alternative Financing Decision

Baker Company needs $1 million to expand its existing plant. Baker management is considering the following two alternative forms of financing:

1.    At the beginning of 2017, issue $1 million of convertible, 10‐year, 10 percent bonds. Each $1,000 bond can be converted into 20 shares of Baker $10 par value common stock. The conversion may take place any time after three years. Please explain what is this mean? How can I convent the bonds to stocks?

 

2.    At the beginning of 2017, issue 10,000 shares of $100 par value, $10, redeemable preferred stock. The preferred is redeemable at $102 ten years from the date of issue. Please explain and what's this mean in plain English?

 

Baker's management is concerned about the effects of the two alternatives on cash flows, their financial statements, and future financing for other planned expansion activities. Also, existing debt covenants restrict the debt‐to‐equity ratio to 2:1; $1 million in new debt would cause the debt‐to‐equity ratio to be close to 2:1. Baker believes that either the bonds or the preferred stock could be sold at par value. Their income tax rate is 34 percent.

Baker Company common stock is currently selling for $45 per share.

Please explain the ratio of 2:1, tax rate and $45 per share. How can I use these numbers to answer the below required questions? Thanks so much!

 

Required:

 

1.    Compare the effects of the two financing alternatives on Baker Company's balance sheet, income statement, and cash flows under current U.S. GAAP. Your comparison should consider 2017 and future years, the potential conversion of the bonds, and the debt covenant restrictions.

2.    If the FASB were to decide to recognize the value for conversion (conversion feature) as equity, would this have an impact on Baker Company's decision? How would Baker's financial statements be affected if it chose the convertible bond alternative? Would the decision to select convertible bonds versus redeemable preferred stock be affected, especially in light of the concern regarding the debt covenant restrictions?


Answers from the prior tutor:

The theoretical and current U.S. GAAP treatments for convertible bonds

Before the reporting of convertible bonds, the consistency of the treatment in the financial statements gives more information or details on the value of debt provided by relevant users reading the statements. The most considered aspect is whether the treated item satisfies to be a liability or an equity during the issuance time of the bond (Bonds, 2017). During the period of converting the fair value of a debt can offer relevant information or details about the users of financial statements.


The current U.S. GAAP treatment for redeemable preferred stock

FASB No. 150 orders the way of classifying redeemable stock into liabilities and assets under the various circumstances. Te disclosure of redeemable preference stock must be reported under the shareholders' equity (Linsmeier, Partridge, & Shakespeare, 2018). It must be understood that an instrument can be redeemed upon the occurrence of an event defined during the time of acquiring the stock.


Effect of convertible bonds on Baker Company's financial statements

The convertible bonds have the ability of affecting the three major components of the statement of financial position; cash, debt, and common stock (Bonds, 2017).


Effect of redeemable preferred stock on Baker Company's financial statements

During the period of liquidating a company, the preferred stock holders have preference over other shareholders because they must be considered first before the payment of other liabilities (Linsmeier, Partridge, & Shakespeare, 2018). However, the preferred stock can only be purchased back or sold at certain dates set by the agreement of stock records.


N/B:- Redeemable preferred stock is better than convertible bonds because it guarantees of regular income at a considerable situation./ However, convertible bonds may fail to convert at the period when the holders require the use of the funds. But preferred stock have the best way of helping and assuring holders of regular and prioritized income.


References

Bonds, C. (2017). Convertible Debt Instruments in International Tax Law-Part 2. EURoPEan TaxaTIon.

Linsmeier, T., Partridge, C., & Shakespeare, C. (2018). Do Common Equity Investors Evaluate Companies' Preferred Stock Based on Contractual Settlement Provisions or Other Economic Characteristics?. Available at SSRN 3253324.

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