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18. Which of the following is most likely a benefit of debt covenants for the borrower? A. Reduction in the cost of borrowing. B. Limitations on the company’s ability to pay dividends. C. Restrictions on how the borrowed money may be invested.

Ans: A. Debt covenants are restrictions imposed by the lender on the borrower to protect the lender’s position. Debt covenants can reduce default risk and thus reduce borrowing costs. B is incorrect. This is a disadvantage of using debt covenants for the borrower. C is incorrect. This is a disadvantage of using debt covenants for the borrower.

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17. A capital lease requires annual lease payments of $2,000 at the start of each year. Fair value of the leased equipment at inception of the lease is $10,000 and the implicit interest rate is 12 percent. If the present value of the lease payments equals the fair value of the equipment at the inception of the lease, the interest expense (in $) recorded by the lessee in the second year of the lease is closest to: A. 960. B. 1,104. C. 1,200.

Ans: A. Year Starting Balance Interest Expense @12% Lease Payment Principal Reduction Ending Balance 1 10,000 0 2,000 2,000 8,000 2 8,000 960

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16. A company issued $2,000,000 of bonds with a 20 year maturity at 96. Seven years later, the company called the bonds at 103 when the unamortized discount was $39,000. The company would most likely report a loss of: A. $60,000. B. $99,000. C. $138,000.

Ans: B. Redemption cost $2,060,000 $2,000,000 x 103/100 Carrying amount retired 1,961,000 $2,000,000 – $39,000 Loss on redemption $99,000

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15.  Compared to classifying a lease as a financing lease, if a lessee reports the lease as an operating lease it will most likely result in a: A. lower return on assets. B. higher debt-to-equity ratio. C. lower cash from operations.

Ans: C. The cash from operations is lower if the lease is classified as an operating lease, because the full lease payment is shown as an operating cash outflow. If it were classified as a financing lease, only the portion of the lease payment relating to interest expense reduces the operating cash flow and the portion of the lease payment that reduces the lease liability is classified as a financing cash flow. Therefore, the lessee’s cash from operations tends to be lower under operating leases. The following two figures summarize the difference between the effects of finance leases and operating leases on the financial statements and ratios of the lessee. Figure 1: financial statement impact of lease accounting Finance Operating Assets Higher Lower Liability (current and long-term) Higher Lower Net income (in the early years) Lower Higher Net income (later years) Higher Lower Total net income Same Same EBIT (operating income) Higher Lower Cash flow from operations Higher Lower Cash flow from financing Lower Higher Total cash flow Same Same Figure 2: ratio impact of lease accounting Finance Operating Current ratio (CA/CL) Lower Higher Working capital (CA-CL) Lower Higher Asset turnover (Revenue/TA) Lower Higher Return on assets*(NI/TA) Lower Higher Return on equity*(NI/SE) Lower Higher Debt/ Asset Higher Lower Debt/ Equity Higher lower

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14. A company, which prepares its financial statements in accordance with IFRS issues ￡5,000,000 face value ten year bonds on January 1, 2010 when interest rates are 5.50%. The bonds carry a coupon of 6.50%, with interest paid annually on December 31. The carrying value of the bonds as of December 31, 2011 will be closest to: A. ￡4,695,562. B. ￡5,301,000. C. ￡5,316,000.

Ans: C. The bond proceeds are determined by taking the present value of the coupon stream and terminal payment at the interest rate of 5.5%: Proceeds = 5,000,000 x 6.5% x PVA(10y, 5.5%) + 5,000,000 x PV(10y, 5.5%) = 325,000 x PVA(10y, 5.5%) + 5,000,000 x PV(10y, 5.5%) = 5,376,881 Where PVA(10y, 5.5%) is the present value interest factor for an annuity of $1 for 10years at 5.5%, and PV(10y, 5.5%) is the present value interest factor for $1 to be received in 10years when rates are 5.5% Using the effective annual interest (EAI) rate method which is required under IFRS. Year Carrying Amount at Start of Year Interest Expense @ EAI Interest Payment @ Coupon Rate Amortisation of Premium Carrying Amount @ End of Year 2010 5,376,881 295,728 325,000 29,272 5,347,609 2011 5,347,609 294,119 325,000 30,881 5,316,728 Alternatively, take the PV of the cash flows over the remaining 8 years at 5.5% 5,000,000 x 6.5% x PVA(8y, 5.5%) + 5,000,000 x PV(8y, 5.5%) = 5,316,728

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13. Given the following information about a company: (€ millions) 2011 2010 Short-term borrowings 2,240 5,400 Current portion of long-term interest bearing debt 2,000 1,200 Long-term interest bearing debt 12,000 9,000 Total shareholders’ equity 23,250 21,175 EBIT 3,850 3,800 Interest payments 855 837 Operating lease payments 800 800 What is the most appropriate conclusion an analyst can make about the solvency of the company? Solvency has: A. improved because the debt-to-equity ratio decreased. B. deteriorated because the debt-to-equity ratio increased. C. improved because the fixed charge coverage ratio increased.

Ans: A. The debt–equity ratio decreased, thereby improving solvency; the fixed charge ratio remained the same. 2011 2010 Comments Debt-to-equity ratio = =70% =74% Ratio decreased: Company has less financial risk; more solvent Fixed charge coverage ratio = =2.81 =2.81 No change in FCC ratio

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12. On 1 January 2011 the market rate of interest on a company’s bonds is 5% and it issues a bond with the following characteristics: Face value €50 million Coupon rate, paid annually 4% Time to maturity 10 years (31 December 2020) Issue price (per €100) 92.28 If the company uses IFRS, its interest expense (in millions) in 2011 is closest to: A. €1.846. B. €2.307. C. €2.386.

Ans: B. IFRS requires the effective interest method for the amortization of bond discounts/premiums. The bond is issued for 0.9228 × €50 million = €46.140. Interest expense = Liability value × Market rate at issuance = 0.05 × €46.140 = €2.307.

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11. Which of the following is most likely a reason that a lessor can offer attractive lease terms and lower cost financing to a lessee? Because the: A. Lessor retains the tax benefits of ownership. B. Lessor avoids reporting the liability on its balance sheet. C. Lessee is better able to resell the asset at the end of the lease.

Ans: A. The lessor often retains the tax benefits of ownership of the leased asset, which allows the lessor to pass those savings along to the lessee in the form of lower financing costs or other attractive terms. B is incorrect. Lessor owns the asset. C is incorrect. The lessee does not own the asset.

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10. On 1 January 2009, a company that prepares its financial statements according to IFRS issued bonds with the following features: ? Face value ￡20,000,000 ? Term 5 years ? Coupon rate 6% paid annually on December 31 ? Market rate at issue 4% The company did not elect to carry the bonds at fair value. In December 2011 the market rate on similar bonds had increased to 5% and the company decided to buy back (retire) the bonds after the coupon payment on December 31. As a result, the gain on retirement reported on the 2011 statement of income is closest to: A. ￡340,410. B. ￡371,882. C. ￡382,556.

Ans. C. The market value of debt at retirement can be determined by discounting the future cash flows at the current market rate (5%) using a financial calculator: FV = 20,000,000; i = 5%; PMT = 1,200,000; N = 2; Compute PV = 20,371,882 The book value after the third interest payment (two payments remaining) can be found either using a financial calculator and the market rate at the time of issue (4%) or an amortization table (shown below). FV = 20,000,000; i = 4%; PMT = 1,200,000; N = 2; Compute PV = 20,754,438. The bond’s initial value (required for amortization) can be found using a financial calculator: FV = 20,000,000; i = 4%; PMT = 1,200,000; N = 5; Compute PV = 21,780,729. Principal value at beginning of year Interest expense 4% Coupon 6% Discount amortization 2009 21,780,729 871,229 1,200,000 328,771 2010 21,451,958 858,078 1,200,000 341,922 2011 21,110,036 844,401 1,200,000 355,599 Book value at end of 2011=21,110,036-355,599=20,754,438 Gain=Book value of debt – Market value         = 20,754,438 – 20,371,882 =382,556

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9. A retail company that leases the majority of its space has: ? total assets of $4,500 million, ? total long-term debt of $2,125 million, and ? average interest rate on debt of 12%. Note 8 to the 2011 financial statements contains the following information about the company’s future beginning of year lease commitments: Note 8: Operating leases Year Millions 2012 $200 2013 200 2014 200 2015 200 2016 200 total $1,000 After adjustment for the off-balance-sheet financing, the debt-to-total-assets ratio for the company is closest to: A. 55%. B. 57%. C. 65%.

Ans: A. The present value of the operating leases should be added to both the total debt and the total assets. The present value of an annuity due of $200 for 5 years at 12% = $807.5. (N = 5; I = 12; PMT = 200; Mode = Begin) Adjusted debt to total assets = (2,125 + 807.5) ÷ (4,500 + 807.5) = 55.3%.