cityboy

31. Which of the following statement most accurately reflects the effective interest method of amortizing bond premium and discount? A. using the effective interest method results in a different interest expense each period. B. The coupon interest rate is the market interest rate at the time the debt was issued. C. A bond sells at a premium when the market interest rate exceeds the coupon rate.

Ans: A. The effective interest method requires multiplying the yield-to-maturity of the bond by the net book value. The net book value approaches par value as the bond nears maturity. Periodic interest expense increase (decreases) as the bond’s book value increase (decreases). B is incorrect. The coupon interest rate for a bond may be higher or lower than the market interest rate at the date of issuance. Higher coupon rates than market rates indicate a premium to par value, and lower coupon rates than market rates indicate a discount from par value. C is incorrect. A bond sells at a premium when the market interest rate is less than the coupon t\rate. If the market rate exceeds the coupon rate, the bond will sell at a discount.

cityboy

32. Madison Inc. is planning a bond issue. They are considering issuing either a straight coupon bond or a coupon bond with warrants attached. The proceeds from either issue would be the same. What will be the effect on their interest expense and balance sheet liability if they issue the bonds with warrants as compared to the straight bonds? For the bonds with warrants the: Interest expense will be Balance sheet liability will be A Lower Lower B Lower Higher C Higher Lower

Ans: A. The portion of the proceeds attributable to the warrants would be classified as equity, thus the portion classified as a liability would be smaller (lower). The lower balance sheet value would lead to a lower interest expense when it is calculated. The interest expense is based on the liability at the beginning of the period, not the coupon payment.

cityboy

33. Compared to an operating lease, all other things being equal, over the term of a finance lease, A. The interest coverage ratio will decrease. B. The return on assets ratio will decrease. C. The asset turnover ratio will increase.

Ans: C. Lease capitalization will increase asset balances resulting in a lower asset turnover (net sales / average total assets). As the leased asset is depreciated and the asset balance becomes smaller, the ratio will increase. The lower the asset balance is (or becomes), the higher the asset turnover ratio will be. A is incorrect. The interest coverage ratio increases over the lease term of a finance lease as the interest on the lease liability declines as the principal is paid down. On the other hand, the interest coverage ratio will be higher at all times with an operating lease as there is no interest. B is incorrect. With a finance lease, the return on assets will increase as the earnings increase due to the lower interest expense on the lease liability and the declining asset base resulting from depreciation. Consequently, later in the lease term, higher earnings will be returns to lower asset levels and the asset turnover ratio will increase, not decrease.

cityboy

34. Bao Inc. issued its Class H series bonds at $10,400 on 1/1/x3. Class H bonds have a 10% coupon paid semi-annually and a face value of $10,000, maturing in two years. Using the effective interest method, calculate the amount of interest expense associated with the Class H bonds reported by Bao for the period ending 12/31/x3. A. $405. B. $808. C. $1,000.

Ans: B. The periodic payment is $500 or one-half of the 10% annual coupon. The yield-to-maturity is solved for, using a financial calculator, as 3.90% semi-annually (see below). At the end of the first reporting period (Year 1), the total interest expense is $807.52 (=$405.60 + 401.92). Periodic coupon payment = semi-annual payment x coupon rate x face value =0.5 x 10.0% x $10,000 = $500 Semi-annual yield-to-maturity: N=4; PV= -$10,400; PMT =$500; FV = $10,000 Compute 1/Y = 3.90 semi-annual effective interest rate (3.9 x NBV) Interest exp. Coupon Premium NBV Period 0 $400.00 $10,400.00 Period 1 $405.60 $500.00 305.60 10,305.60 Period 2 401.92 500.00 207.52 10,207.52 Period 3 398.09 500.00 105.61 10,105.61 Period 4 394.12 500.00 -0.27(~$0) 9,99.73 (~$10,000) Interest expense = NBV of bond at end of previous period x effect interest rate NBV t= NBV t-1 + interest expense – coupon Interest expense = 405.60 + 401.92 = 807.52

cityboy

35. A retail company that leases the majority of its space has total assets of $4,500 million and total long-term debt of $2,125 million bearing an average interest rate of 10%. Note 8: Operating leases Year Millions 2011 $200 2012 200 2013 200 2014 200 2015 200 2016 and thereafter 1,260 total $1,960 After adjustment for the off-balance-sheet financing, the debt-to-total-assets ratio for the company is closest to: A. 58%. B. 62%. C. 72%.

Ans: A. The present value of the operating leases should be added to both the total debt and the total assets. To estimate the present value it is appropriate to estimate the number of years of lease payments reflected in the 2016 and thereagter figure. Based on the constant expense shown in the first 5 years, there are 9 (1,260/140) more payment for total of 14 payments. Adjusted debt to total assets = (2,125+1,134)/(4,500+1,134)=57.8%

cityboy

36. Matrix pricing is a process in which a bond’s yield-to-maturity is determined from bonds currently available in the market that have similar attributes as the bond being considered. Matrix pricing is most similar to the : A. Debt-rating approach only. B. Yield-to-maturity approach. C. Yield-to-maturity approach and Debt-rating approach.

Ans: A. Matrix pricing (as describe) is an example of the debt-rating approach only.

cityboy

37. The following information is available from a company’s 2012 financial statements: Note 6: employee costs. (all figures in $thousands) 2012 2011 Wages and salaries $21,000 $18,500 Share-based payment costs (note 15) 600 425 Defined contribution pension plan 1,525 1,462 Retirement benefit obligations (note 17) 728 620 Other employee costs 3,233 3,080 Total employee costs $27,086 $24,087 Note 17: retirement benefit obligations Amounts recognized in the income statement for the year (all figures in $thousands) 2012 2011 Current service cost $692 $588 Interest cost on pension obligation 80 65 Expected return on plan assets (50) (45) Past service costs recognized in the year 6 12 Total income statement charge $720 $620 The pension expense (thousands) reported in 2012 is closest to: A. $1,525. B. $2,217. C. $2,253.

Ans: C. The pension expense would be the sum of the expense for the defined contribution plan and the defined benefit plan (retirement benefit obligation): 1,525+728=2,253.

cityboy

38. Bao Capital issued bonds in 2006 that mature in 2016. The measurement basis used for the bonds on the 2008 balance sheet will be: A. market value. B. historical cost. C. amortized cost.

Ans: C. Bonds payable issued by a company are financial liabilities that are measured at amortized cost.

cityboy

39.  If market interest rates have changed materially since a firm issued a bond, and the firm does not use the fair value reporting option, how is the change in the market value of the firm’s debt most likely to be reported in the firm’s financial statements? A. The gain or loss in market value must be calculated and disclosed in the footnotes to the financial statements. B. Net income and equity are unaffected, but the change is disclosed by the firm’s management. C. Net income is unaffected, but the change in market value is recorded in other comprehensive income.

Ans: B. Material changes in the firm’s cost of debt capital should be included in the Management Discussion and Analysis section of the financial statements. If the firm does not use fair value reporting of debt obligations, net income and shareholders’ equity are not affected by changes in the market value of the firm’s debt, and disclosing its gain or loss in market value is not required.

cityboy

40. A firm that reports its lease of a conveyer system as an operating lease must disclose: A. only the annual lease payment. B. minimum lease payments for each of the next five years and the sum of lease payments more than five years in the future. C. minimum lease payments for each of the next ten years and the sum of lease payments more than ten years in the future.

Ans: B. Whether a lease is an operating or finance (capital) lease, both U.S.GAAP and IFRS require disclosure of the minimum lease payments for each of the next five years and the sum of minimum lease payments more than five years in the future.