anshultongia

Millennium Airlines Corp. (MAC) reported the following year-end data:

Rent expense	$23 million
Depreciation expense	$17 million
EBIT	$88 million
Interest expense	$22 million
Total assets	$500 million
Long-term debt	$150 million
Capital lease obligations	$100 million
Total equity	$250 million

MAC also reported that the present value of its operating leases at the beginning of the year was $240 million. The term on the leases was 8 years. What are the effects on the leverage (liabilities / total capital) and times interest earned if an analyst chooses to capitalize the leases at a rate of 10% using a straight-line depreciation assumption? Leverage measures:

A) increase to 65% from 50% and times interest earned decreases to 1.33 times from 4 times.

B) increase to 65% from 50% and times interest earned decreases to 1.76 times from 4 times.

C) remain unchanged and times interest earned decreases to 1.23 times from 4 times.

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Using the reported data the leverage measure is 0.50 ((150 + 100) / (150 + 100 + 250)) and times interest earned is 4 times (88 / 22). Following the capitalization of the operating leases the balance sheet values are:

Total assets	$710 million	(500 assets + 240 leases - 30 depreciation on leases)
Value of operating leases	$210 million	(increase in financing liabilities)
Long-term debt	$150 million	unchanged
Capital lease obligations	$100 million	unchanged
Total equity	$250 million	unchanged

Therefore, the leverage measure is 0.65 ((210 + 150 + 100) / (210 + 150 + 100 +250)).
The income statement is affected in the following way:

reported EBIT	88
+ rent expense	23
= EBIT excluding cost of operating leases	111
- depreciation of operating leases	30	($240 million/8 years)
= adjusted EBIT	81

Interest expense will increase by $24 million ($240 million × 0.10) to $46 million. Therefore times interest earned decreases to 1.76 times (81 / 46). Recall that when capitalizing operating leases interest expense is calculated as the present value of the lease obligations multiplied by implied interest rate.

anshultongia

Northern Bottling (NB) currently shows minimum expected operating leases over the next 5 years of $3 million, $2.5 million, $2 million, $2 million, and $1.5 million. The firm’s current financing rate is 6.75% and the rate implicit in the lease contract is 7%. What adjustments would an analyst make to modify the balance sheet of NB to include this off-balance sheet financing? Increase long-term:

A) assets and long-term liabilities by $9.22 million.

B) assets and long-term liabilities by $9.27 million.

C) liabilities by $9.27 million and decrease equity by $9.27 million.

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Recall that the interest rate in this present value computation is the lower of the firm’s financing rate or the interest rate that is implicit in the lease.  Therefore, the PV (operating leases) is:

= 3 / (1 + 0.0675) + 2.5 / (1 + 0.0675)2 + 2 / (1+ 0.0675)3 + 2 / (1 + 0.0675)4 + 1.5 / (1 + 0.0675)5

= 9.27 million

The proper adjustment is to increase both long-term assets and liabilities by the same amount.

anshultongia

Northern Bottling (NB) currently shows minimum expected operating leases over the next 5 years of $3 million, $2.5 million, $2 million, $2 million, and $1.5 million. The firm’s current financing rate is 6.75% and the rate implicit in the lease contract is 7%. What adjustments would an analyst make to modify the balance sheet of NB to include this off-balance sheet financing? Increase long-term:

A) assets and long-term liabilities by $9.22 million.

B) assets and long-term liabilities by $9.27 million.

C) liabilities by $9.27 million and decrease equity by $9.27 million.

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Recall that the interest rate in this present value computation is the lower of the firm’s financing rate or the interest rate that is implicit in the lease.  Therefore, the PV (operating leases) is:

= 3 / (1 + 0.0675) + 2.5 / (1 + 0.0675)2 + 2 / (1+ 0.0675)3 + 2 / (1 + 0.0675)4 + 1.5 / (1 + 0.0675)5

= 9.27 million

The proper adjustment is to increase both long-term assets and liabilities by the same amount.

anshultongia

Northern Bottling (NB) currently shows minimum expected operating leases over the next 5 years of $3 million, $2.5 million, $2 million, $2 million, and $1.5 million. The firm’s current financing rate is 6.75% and the rate implicit in the lease contract is 7%. What adjustments would an analyst make to modify the balance sheet of NB to include this off-balance sheet financing? Increase long-term:

A) assets and long-term liabilities by $9.22 million.

B) assets and long-term liabilities by $9.27 million.

C) liabilities by $9.27 million and decrease equity by $9.27 million.

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Recall that the interest rate in this present value computation is the lower of the firm’s financing rate or the interest rate that is implicit in the lease.  Therefore, the PV (operating leases) is:

= 3 / (1 + 0.0675) + 2.5 / (1 + 0.0675)2 + 2 / (1+ 0.0675)3 + 2 / (1 + 0.0675)4 + 1.5 / (1 + 0.0675)5

= 9.27 million

The proper adjustment is to increase both long-term assets and liabilities by the same amount.

anshultongia

Adjustments for off-balance-sheet items include all but which of the following?

A) Capitalizing operating leases, including this amount as an asset and a liability.

B) Using the equity method in place of the proportionate consolidation to reflect the investment in affiliates.

C) Estimating the probable obligation for contingent liabilities.

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The correct statement is that proportionate consolidation should be used in place of the equity method.

anshultongia

A firm has booked as a sale, the transfer of $100 million in short-term accounts receivable to Public Finance Co., subject to recourse. The notes to the financial statements disclose that as of the end of the fiscal year, $80 million remained uncollected. In order to reflect this on the balance sheet, which of the following adjustments must be made?

A) Decrease cash and increase accounts receivable.

B) Increase accounts receivable and increase current liabilities.

C) Decrease retained earnings and increase accounts receivable.

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Since the accounts receivable were sold with recourse, the risk on uncollected accounts remains with the company

anshultongia

What does the LIFO reserve measure?

A) The accumulated difference between the reported inventory balance and the cost of that inventory if first in, first out (FIFO) had been used.

B) The results of older inventory flowing to cost of goods sold (COGS).

C) The overstatement relative to the current cost of inventory.

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The LIFO reserve measures the accumulated difference between the reported inventory balance and the cost of that inventory if FIFO had been used

anshultongia

Due to a change in accounting standards, TRK Construction’s QSPE must now be consolidated. Assume the current ratio before consolidation is 1.10. Consolidation will most likely result in which of the following:

A) an increase in the current ratio.

B) a decrease in the current ratio.

C) no change in the current ratio.

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The correct treatment for consolidation of the QSPE would be an increase in assets and in liabilities by the same amount. If the current ratio is greater than one, consolidation would decrease the current ratio.

anshultongia

Assume that inventory costs are increasing in line with an overall inflation rate of 3 percent. If a firm reports inventory using the last in, first out (LIFO) method, which of the following is most accurate?

A) The less expensive inventory is flowing out to COGS.

B) Lower profits and lower taxes are reported because new inventory is flowing out to COGS.

C) LIFO reserve measures the accumulation of taxes paid.

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LIFO firm reports lower profits and lower taxes because all of the new, mores expensive inventory is flowing out to COGS thus, LIFO reserve measures the accumulation of taxes not paid and profits not recognized

anshultongia

An analyst finds return-on-equity (ROE) a good measure of management performance and wants to compare two firms: Firm A and Firm B. Firm A reports net income of $3.2 million and has a ROE of 18. Firm B reports income of $16 million and has an ROE of 16.

A review of the notes to the financial statements for Firm A, shows that the earnings include a loss from smelting operations of $400,000 and that the firm has exited this business. In addition, the firm sold the smelting equipment and had a gain on the sale of $300,000.

A similar review of the notes for Firm B discloses that the $16 million in net income includes $2.6 million gain on the sale of no longer needed office property. Assume that the tax rate for both firms is 36%, and that the notes describe pre-tax amounts. Which of the following is closest to the “normalized” ROE for Firm A and for Firm B, respectively?

A) 17.1 and 16.9.

B) 16.0 and 18.0.

C) 18.4 and 14.3.

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The ROE for Firm A is adjusted for the $400,000 loss on discontinued operations and the $300,000 non-recurring gain. The ROE for Firm B is adjusted to remove the effects of the $2.6 million one-time gain.

The first step in this problem is to solve for equity using ROE. Then, “normalize” net income by adjusting for discontinued operations and non-recurring items. Then, solve for “normalized” ROE.

Firm A:
18% = 3,200,000 / EquityA
EquityA = 17,777,778 (rounding)
Normalized Net IncomeA = 3,200,000 + (1 – 0.36)(400,000 – 300,000)
Normalized ROEA = 3,264,000 / 17,777,778 = 18.360%

Firm B:
16% = 16,000,000 / EquityB
EquityB = 100,000,000
Normalized Net IncomeB = 16,000,000 + (1 – 0.36)(–2,600,000)
Normalized ROEB = 14,336,000 / 100,000,000 = 14.336%

18.360 and 14.336 are closest to 18.4 and 14.3