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6. An analyst is comparing the financial statements of Company A and Company B. both companies have incurred expenses of approximately $250 million in the current year to expand their production facilities. Company A is highly leveraged. Company B does not have any outstanding debt and paid the $250 million from internal cash reserves. The most likely effect of the difference in the capital structures of the two companies will be: A. Company A will report higher asset balances related to the facilities under construction. B. The companies will report the same asset balances related to the facilities under construction. C. Company A’s interest coverage ratio will be lower than it would have been if the company had expensed all interest.

Ans. A. Since Company A is leveraged, it will be required to capitalize the interest related to the construction project even if there was no borrowing specially for the $250 million (an assumption is made that the money actually came from some kind of borrowing, even if there is no specific loan for the amount). Company B on the other hand, will not have any interest to capitalize. As a result, Company A’s balance sheet will reflect an amount in excess of the $250 million for the facilities under construction, while Company B will reflect only the $250 million. B is incorrect. Company A will report an amount in excess of the $250 million in construction costs, which includes the capitalized interest related to the project. Company B, on the other hand, will not have any capitalized interest to report. C is incorrect. If interest is capitalized, EBIT is unchanged and interest expense falls. These changes will cause the interest coverage ratio to be higher, not lower.

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5. An analyst has gathered the following information from the current year fixed asset disclosures of three competing companies: Building(Gross) Accumulated Dep. Dep. expense Company X $69 $25 $5 Company Y $320 $140 $19 Company Z $145 $37 $11 Based on this information, which company is depreciating its building over the longest average period? A. Company X. B. Company Y. C. Company Z.

Ans: B. Based on the average depreciable lives of these buildings, Company Y’s buildings are being depreciated over the longest average period. The average depreciable lives can be calculated as follows: Company X= Company Y= Company Z =

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4. Which of the following would most likely be lower in the early years of an asset’s life using accelerated depreciation methods rather than straight-line depreciation? A. Investing cash flow B. Shareholder’s equity C. Cash flow from operations

Ans: B The greater depreciation expense in the early years of an asset’s life using accelerated depreciation methods rather than straight-line depreciation would lead to lower net income and lower retained earnings in those years. Lower retained earnings would result in lower shareholders’ equity. Effect of depreciation method on financial statements and key ratios: variable Straight-line (early year effects) Accelerated (early year effects) Earnings Higher- depreciation expense is lower. Lower- depreciation expense is higher. Shareholders’ equity Higher-asset write-down is lower and net earnings is higher. Lower- asset write-down is higher and net earnings is lower. Pretax cash flow Same- depreciation is a noncash expense. Same- depreciation is a noncash expense. Profit margin Higher- earnings are higher. Lower- earnings are lower. Current ratio Same- depreciation affects only long-term assets. Same- depreciation affects only long-term assets. Asset turnover Lower- assets are higher. Higher- assets are lower. Debt-to-equity Lower- net worth is higher. Higher- net worth is lower. Return on assets Higher- both earnings and assets are higher with earnings higher by the larger percentage. Lower- both earnings and assets are lower with earnings lower by the larger percentage. Return on equity Higher- both earnings and net worth are higher with earnings higher by the larger percentage. Lower- both earnings and net worth are lower with earnings lower by the larger percentage.

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3. The effects on a firm’s financial statement in the initial year when cost of an asset is expensed rather than capitalized are: A. Pre-tax cash flow is lower and the debt-to-equity ratio is higher. B. Pre-tax cash flow remains the same and the debt-to-equity ratio is lower. C. Pre-tax cash flow remains the same and the debt-to-equity ratio is higher.

Ans: C Pre-tax cash flow stays the same because depreciation (or amortization) is a non-cash expense. However, when the cost is expensed rather then capitalized, net income and retained earnings are lower, resulting in a lower equity. So the debt-to-equity ratio will be higher. Effects of expensing versus capitalizing costs in the year of the capitalization: variable expensing Capitalizing Shareholders’ equity Lower- earnings are lower Higher- earnings are higher Earnings Lower-expenses are higher Higher- expenses are lower Pretax cash generated from operating activities Lower- expenses are higher Higher- expenses are lower Cash generated from investing activities No effect- no long-term asset is put on the balance sheet Lower-long-term asset is acquired for cash Pretax total cash flow Same-amortization is not a cash expense Same-amortization is not a cash expense Profit margin Lower- earnings are lower Higher- earnings are higher Asset turnover Higher- assets are lower Lower-assets are higher Current ratio Same- pretax because only long-term assets are affected Same- pretax because only long-term assets are affected Debt-to-equity Higher-shareholders’ equity is lower Lower-shareholders’ equity is higher ROA Lower-earnings are lower % wise than the lower assets Higher--earnings are higher % wise than the higher assets ROE Lower-earnings are lower % wise than the lower shareholders’ equity Higher--earnings are higher % wise than the higher shareholders’ equity Stability over time Less stable earnings and ratios because large expenses may be sporadic More stable earnings and ratios because amortization smoothes earnings over time

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2. A company records an asset retirement obligation (ARO) because of environmental damage. Which of the following will most likely result from the recording an ARO in any given year? A. An increase in return on equity and an increase in depreciation expense B. An decrease in return on equity and an increase in depreciation expense C. An decrease in return on equity and an decrease in depreciation expense

Ans: B Obligation associated with the retirement of tangible fixed assets are referred to as asset retirement obligations (AROs) and include costs for cleaning up the operating site and restoring it to pre-existing conditions, including rectifying any environmental damages. ARO accounting requires companies to record an asset and a related liability for costs incurred to remedy environmental damage. The asset increase will result in an increase in depreciation expense that will reduce net income. Lower net income will reduce the company’s return on equity.