262 Part 1 Finunciul Acc:ounting
Cases
Case 9-'l
Xytech, Inc.*
Xytech was a high-tech company that had been started
by three partners in early 20X0. Their successful prod-
uct designs led to rapid growth of the company, with
resulting needs for additional capital to support the
growth. This case describes the major financing trans-
actions entered into by Xytech in its first l0 years of
existence. The firm's earnings history also is given.
You are to write a journal entry for each transaction
as it is described. You should be explicit about what
noncurrent liability and owners' equity-that is, in-
vested capital-accounts are affected by the transac-
tions, but effects on assets (including cash) and current
liabilities can be recorded in a single account, 'A&CL."
20X0: The firm began as a partnership on January
10, with the three equal partners, Able, Baker, and
Cabot, each contributing $ 100.,000 capital. The ac-
countant set up a capital account for each of the three
partners. On April I the partners arranged with a bank
a $ 100,000, 8 percent, five-year "balloon" note, which
meant that only quarterly interest was payable for five
years,, with the principal due in full as a lump sum at
the end of the fifth year. The firm's net loss for 20X0
was $54,,000. A salary for each partner was included in
the calculation of net loss; no other payments were
made to the partners.
20X1: To help the firm deal with a short-term liq-
uidity problem, oo April 26, Cabot liquidated some
personal securities and loaned the firm the $50,000
proceeds. Cabot expected to be repaid these funds in
no more than one year. In October Baker's ownership
interest in the firm was sold out equally to Able and
Cabot, with Baker receiving a total of $ I 10,000 in
notes and cash from Able and Cabot. The firm had
$ 12,000 net income for the year. Able and Cabot
planned to incorporate the firm as of January l,2AX2.
Prepare a statement of invested capital for the partner-
ship as of Decembcr 3 1 , 20X l .
20X2: The firm was incorporated on January l, as
plarrned. The articles of incorporation authorized
500 shares of $ 100 par value common stock, but only
100 sharcs were issued- 50 each to Able and Cabot. On
* Copyright O Robert N. Anthony, Harvard Business School.
March 2l the bank agreed to increase the $ 100,000
balloon note to $ 150,000; the $50,000 proceeds were
used to repay Cabot's $50,000 loan, The net income
for the year was $26,000.
20X3: In anticipation of a public offering of Xytech,
Inc., stock, the firm effected a I ,000-for- I stock split in
November. The year's net income was $43,000. Calcu-
late the 20X3 basic earnings per share amount.
20X4: In January the firm went public. An invest-
ment banker sold 100,000 newly issued shares at S7 .7 5
per share. The banker's fee and other issuance costs
amounted to $55,000. The year's net income (after stock
issuance costs) was $68,000. Prepate a statement of in-
vested capital as of December 31,20X4.
20X5: In January the company issued 500 2}-year
bonds with a face value of $ I ,000 each and a coupon
rate of 6 percent. Although the bonds were issued at
p&r, because of issuance costs the proceeds were only
$950 per bond. Part of the proceeds was used to repay
the firm's prior long-term debt. The year's net income
was $85,000.
20X6: [n April Able and Cabot each sold 25,000 of
their common shares, receiving proceeds of $ I 1 per
share. The company earned net income of $ 1 I 1,000.
On December 3 I the firm declared a dividend of $0.15
',
per share, payable January 3 1, 20X7 , to holders of
record as of January 15. Prepare a statement of invested
capital as of December 31 , 19X6.
20X7: Feeling that the market was undervaluing the
company's stock, in June the management decided to
purchase 20,000 shares on the open market. The pur-
chase was effected July I ataprice of $ l0 per share. The
shares were held as treasury stock, avarlable for possi-
ble reissuance. The year's net income was $ 152,000. In
Decembeq a $0.20 per share dividend was declared,
payable the following month. Calculate the year's earn-
ings per share.
20XB: In January the company issued 4,000 shares
of convertible cumulative preferred stock with an an-
nual dividend rate of $5 per share. Proceeds of the is-
suance were $200,000. Each share was convertible upon
the holder's demand into two shares of Xytech com-
mon stock. Net income before preferred dividends was

$186,000. In December, a dividend of $0.25 per com-
rnon share was declare d, payable the following month.
Calculate the basic and diluted earnings per share of
common stock in 20X8.
20X9: Net income before preferred stock dividends
was $252,000. Instead of paying a cash dividend to
common stock shareholders, on December 31, the firm
Case 9-2
Innovative Etrgineering eompanyx
Innovative Engineering Company was founded by two
partners, Meredith Gale and Shelley Yeaton, shortly
after they had graduated from engineering school.
Within five years, the partners had built a thriving
business, primarily through the development of a
product line of measuring instruments based on the
laser principle. Success brought with it the need for
new permanent capital. After careful calculation, the
partners placed the amount of this need at $ I .2 mil-
lion. This would replace a term loan that was about to
mature and provide for plant expansion and related
working capital.
At first,, they sought a wealthy investor, or group
of investors, who would provide the $ I .2 million in
return for an interest in the partnership. They soon
discovered, however, that although some investors
were interested in participating in new ventures,
none of them was willing to participate as partner in
an industrial company because of the risks to their
personal fortunes that were inherent in such an
arrangement. Gale and Yeaton therefore planned to
incorporate the Innovative Engineering Company, in
which they would own all the stock.
After further investigation, they learned that Arbor
Capital Corporation, a venture capital finn,, rnight be
interested in providing permanent financing. In think-
ing about what they should propose to Arbor, their first
idea was that Arbor would be asked to provide $ I .2 mil-
lion. of which $1.1 million would be a long-term loan.
For theother 00.,000, Arbor would receive | 0 percent
SI
of the Innovative common stock as a "sweetener." If
Arbor would pay $ I 00.,000 for I 0 percent of the stock,
*
Copyright O James S. Reece.
Chapter 9 Sources o/'Capital: Ov;tters'Equitv 263
declared a 5 percent stock dividend. The market price of
the common stock on December 3 I was $ I 7 per share.
No shares of preferred stock were converted during the
year. Calculate the basic and diluted earnings per share
for 20X9 and prepare a statement of invested capital as
of December 31. What is the company's debt/capitaliza-
tion ratio ?t year-end?
this would mean that the 90 percent that would be
owned by Gale and Yeaton would have a value of
$900,000. Although this was considerably higher than
Innovative's net assets, they thought that this amount
was appropriate in view of the profitability of the prod-
uct line that they had successfully developed.
A little calculation convinced them, however, that
this idea (hereafter, proposal A) was too risky. The re-
sulting ratio of debt to equity would be greater than
100 percent, which was considered unsound for an in-
dustrial company.
Their next idea was to change the debt/equity ratio
by using preferred stock in lieu of most of the debt.
Specifically, they thought of a package consisting of
$200,000 debt, $900,000 preferred stock, and
$ 100,000 common stock (proposal B). They learned,
however, that Arbor Capital Corporation was not inter-
ested in accepting preferred stock, even at a dividend
that exceeded the intercst rate on debt. Thereupon,
they approached Arbor with a proposal of $600,000
debt and $600,000 equity (proposal C). For the
6/r-,
$600,000 eqr-rity, Arbor would receive (i.e.., 40 per-
ccnt) of the comrron stock.
The Arbor rcprescntative was considerably inter-
ested in the conrpany and its prospects but explained
that Arbor ordinarily did not participate in a rnajor fi-
nancing of a rclatively new company unless it obtained
at least 50 percent equity as part of the deal. They were
interested only in a proposal for $300,000 debt and
$900,000 for half of thc equity (proposal D). The
debt/equity ratio in this proposal was attractive, but
Gale and Yeaton were not happy about sharing control
of the company eqLlally with an outside party.
Befbrc proccccling furthcr, they decided to see if
thcy could locate another venture capital investor who