a. A = Retirement of 13.99% Zero Coupon Notes.

B = Repayment of 9.125% Note.

C = Additional borrowing on 7.5% Note.
D = Borrowing on 9% Note
E = Borrowing on Medium-Term Notes.
F = Borrowing on 8.875% Debentures
G = Repayment of Other Notes
H = Reclassification of Note
I = Increase in capital lease obligation
b. Campbell Soup’s debt footnote indicates maturities of (in $millions) $227.7 in Year 12,
$118.9 in Year 13, $17.8 in Year 14, $15.9 in Year 15, and $108.3 in Year 16. The remaining long-term debt matures in
excess of 5 years. Given Campbell’s operating cash flow of $805.2 million, solvency does not appear to be a problem.
Further, Campbell reports net income of $401.5, well in excess of its interest expense of $116.2 in Year 11, an interest
coverage ratio of 6.7 [$667.4 + $116.2]/ $116.2). The company should also be able to meet its interest obligations.
Campbell reports total liabilities of $2,355.6 million ($1278+$772.6+$305) against stockholders’ equity of $1,793.4
million, a 1.3 times multiple. The amount of debt does not appear to be excessive. Nor does the company appear to be
underutilizing its equity.Given present debt levels that are not excessive and adequate cash flow, the company should be able
to finance additional investments with debt if desired by management.

a. The economic effects of a long-term capital lease on the lessee are similar to that of an equipment purchase using
installment debt. Such a lease transfers substantially all of the benefits and risks incident to the ownership of property to the
lessee, and obligates the lessee in a manner similar to that created when funds are borrowed. To enhance comparability
between a firm that purchases an asset on a long-term basis and a firm that leases an asset under substantially equivalent
terms, the lease should be capitalized.
b. A lessee should account for a capital lease at its inception as an asset and an obligation at an amount equal to the present
value at the beginning of the lease term of minimum lease payments during the lease term, excluding any portion of the
payments representing executory costs, together with any profit thereon. However, if the present value exceeds the fair value
of the leased property at the inception of the lease, the amount recorded for the asset and obligation should be the fair value.
c. A lessee should allocate each minimum lease payment between a reduction of the obligation and interest expense so as to
produce a constant periodic rate of interest on the remaining balance of the obligation.
d. Von should classify the first lease as a capital lease because the lease term is more than 75 percent of the estimated
economic life of the machine. Von should classify the second lease as a capital lease because the lease contains a bargain
purchase option.
a. A lessee would account for a capital lease as an asset and an obligation at the inception of the lease. Rental payments
during the year would be allocated between a reduction in the obligation and interest expense. The asset would be amortized
in a manner consistent with the lessee's normal depreciation policy for owned assets, except that in some circumstances the
period of amortization would be the lease term.
b. No asset or obligation would be recorded at the inception of the lease. Normally, rental on an operating lease would be
charged to expense over the lease term as it becomes payable. If rental payments are not made on a straight-line basis, rental
expense nevertheless would be recognized on a straight-line basis unless another systematic or rational basis is more
representative of the time pattern in which use benefit is derived from the leased property, in which case that basis would be
used.

a. 1. $200 million
2. As the maturity date approaches the liability will be shown at increasingly larger amounts to reflect the accrual of
interest that will be due at maturity.
3. The annual journal entry is:
Interest expense............................................................ #
Unamortized discount........................................ #
[Note: No cash is involved since it is a zero coupon note.]
b. This amount represents repayment of principal along with interest—it is also equal to the present value of the future
principal and interest payments, discounted at the interest rate in effect at the time of issuance. Cash outflows will mimic the
principal repayment and interest payment schedules per the debt contract(s).
c. The $28 million amount will be paid out. This amount will include $6.5 million of interest implicit in the leases.
d. This is reported in the notes—Note 10 to the financial statements (the Lease footnote). The lease payments will be
expensed as they occur over the years.
e. The company paid an average interest rate of 11.53% on the beginning balance of interest-bearing debt [($116.2 /($202.2
+ $805.8)]. The debt structure did not change substantially during Year 11. At the beginning of Year 12, the company has
interest bearing debt totaling $1,054.8 ($282.2 + $772.6). The relative mix of debt has not changed substantially. Thus, it is
reasonable to predict interest expense by multiplying this beginning balance by the 11.53% average rate experienced in the
previous year. Therefore, the interest expense projection is $121.6 million. (Note that the short-term debt is a bit larger in
percent of the total debt burden so the company may pay an average interest amount of slightly less than the 11.53% paid in
the previous year.)
a. 1/1/Year 1 Enter into Lease Contract
Leased Property under Capital Leases ................................... 39,930
Lease Obligation under Capital Leases............................. 39,930
12/31/Year 1 Payment of Rental
Interest on Leases ........................................................................ 3,194.40 (1)
Lease Obligations under Capital Leases ................................ 6,805.60
Cash ........................................................................................... 10,000
Amortization of Property Rights
Amor. of Leased Property under Capital Leases ................. 7,986 (2)
Leased Property under Capital Leases ............................. 7,986
(1) $39,930 x .08 = $3,194.40
(2) $39,930 ¸ 5 = $7,986
a. Balance Sheet
December 31, Year 1
Assets Liabilities
Leased property under Lease Obligations under
capital leases…………… $31,944 (1) capital leases……. $33,124.40 (2)

Income Statement
For Year Ended December 31, Year 1
Amortization of leased property ....................................................... $ 7,986.00
Interest on leases.................................................................................. 3,194.40
Total lease-related cost for Year 1 ................................................... $11,180.40 (3)
(1) $39,930 - $7,986 = $31,944
(2) $39,930 - $6,805.60 = $33,124.40
(3) To be contrasted to rental costs of $10,000 when no capitalization takes place.
c. The income and cash flow implications from this capital lease
are apparent in the solutions to parts c and d. The student should
note that reported expenses exceed the cash flows in earlier years,
while the
reverse
occurs in
later
years.

a. A
lease
 should be classified as a capital lease when it transfers substantially all of the benefits and risks inherent to the ownership
of property by meeting any one of the four criteria for classifying a lease as a capital lease. Specifically:
· Lease J should be classified as a capital lease because the lease term is equal to 80 percent of the estimated economic
life of the equipment, which exceeds the 75 percent or more criterion.
· Lease K should be classified as a capital lease because the lease contains a bargain purchase option.
· Lease L should be classified as an operating lease because it does not meet any of the four criteria for classifying a
lease as a capital lease.
b. Borman records the following liability amounts at inception:
· For Lease J, Borman records as a liability at the inception of the lease an amount equal to the present value at the
beginning of the lease term of minimum lease payments during the lease term, excluding that portion of the payments
representing executory costs such as insurance, maintenance, and taxes to be paid by the lessor, including any profit thereon.
However, if the amount so determined exceeds the fair value of the equipment at the inception of the lease, the amount
recorded as a liability should be the fair value.
· For Lease K, Borman records as a liability at the inception of the lease an amount determined in the same manner as
for Lease J, and the payment called for in the bargain purchase option should be included in the minimum lease payments.
· For Lease L, Borman does not record a liability at the inception of the lease.
c. Borman records the MLPs as follows:
· For Lease J, Borman allocates each minimum lease payment between a reduction of the liability and interest expense
so as to produce a constant periodic rate of interest on the remaining balance of the liability.
· For Lease K, Borman allocates each minimum lease payment in the same manner as for Lease J.
· For Lease L, Borman charges minimum lease (rental) payments to rental expense as they become payable.
d. From an analysis viewpoint, both capital and operating leases represent economic liabilities as they involve commitments
to make fixed payments. The fact that companies can structure leases as "operating leases" to avoid balance sheet recognition
is problematic from the perspective of analysis of assets. If the leased assets are used to generate revenues, they should be
considered in ratios such as return on assets and other measures of financial performance and condition.

a) An allowance method based on credit sales attempts to match bad debts with the revenues generated by the sales in the
same period. Thus, it focuses on the income statement rather than the balance sheet. On the other hand, an allowance
method based on the balance in the trade receivables accounts attempts to value the accounts receivable at the end of a
period at their future collectible amounts. Thus, it focuses on the balance sheet rather than the income statement. (Note
that both of these allowance methods are acceptable under GAAP.)
b) Carme Company will report on its balance sheet at December 31, Year 1, the balance in the allowance for bad debts
account as a valuation or contra asset account—that is, as a subtraction from the accounts receivable asset. Bad debt
expense can be reported in the income statement as a selling expense, or as a general and administrative expense, or as a
subtraction to arrive at net sales.
c) When examining the reasonableness of the allowance for bad debts, the analyst is interested in assessing the collectibility
of accounts receivable. The analyst is especially interested in changing business conditions and their impact on this
allowance balance (that is, is it sufficient). In addition, the analyst must assess any changes in collectibility assumptions
as they have a direct impact on net income through the determination of bad debt expense. Finally, there is some
evidence that managers use the allowance account (among others) to help manage earnings levels.
a. (i) The average cost method is based on the assumption that the average costs of the goods in the beginning inventory
and the goods purchased during the period should be used for both the inventory and the cost of goods sold computation.
(ii) The FIFO (first-in, first-out) method is based on the assumption that the first goods purchased are the first sold. As a
result, inventory is reported at the most recent purchase prices, while cost of goods sold is at older purchase prices. (iii)
The LIFO (last-in, first-out) method is based on the assumption that the latest goods purchased are the first sold. As a
result, the inventory is at the oldest (less recent) purchase prices, while cost of goods sold is at more recent purchase
prices.
b. In an inflationary economy, LIFO provides a better matching of current costs with current revenue on the income
statement because cost of goods sold is at more recent purchase prices. Also, net cash inflow is generally increased
because taxable income is generally decreased, resulting in payment of lower income taxes.
c. Where there is evidence that the value of inventory to be disposed of in the ordinary course of business will be less than
cost, the difference should be recognized as a loss in the current period. This is done by restating inventory to its market
value in the financial statements. The concept of conservatism, yielding inventory reported at the lower of cost or
market, is the primary justification of this approach.

a. A cost should be capitalized (that is, treated as an asset) when it is expected that the asset will produce benefits in future
periods. The important concept here is that the incurrence of such a cost results in the acquisition of an asset (future
service potential). Not only should the incurrence of the cost result in the acquisition of an asset possessing expected
future benefits, but also the cost should be measurable with a reasonable degree of objectivity. Examples of costs that are
typically capitalized as assets include the costs of merchandise available at the end of an accounting period, the costs of
insurance coverage relating to future periods, and the costs of self-constructed plant or equipment. In contrast, if a cost is
incurred that results in benefits not expected to persist beyond the current period, then the cost is expensed. This expense
treatment reflects the cost of service potential that expired in producing current period revenues.
b. In the absence of a direct basis for associating asset cost with revenue, and if the asset provides benefits for two or more
accounting periods, its cost should be allocated to these periods (as an expense) in a systematic and rational manner.
Examples of systematic and rational allocation of asset cost would include depreciation of fixed assets, amortization of
intangibles, and allocation of rent and insurance costs. When it is impractical, or impossible, to find a reasonable
cause-and-effect relation between revenue and cost, this relation is often assumed to exist. In this case, the asset cost is
allocated to some assumed benefit period in a systematic manner. The allocation method used should be reasonable and
should be applied consistently from period to period.
a. Year 9 retained earnings adjustment for LIFO to FIFO change:
LIFO Reserve x (1- Tax rate) = ($50,000) x (1 - .35) = $32,500 increase
b. Year 9 net income adjustment for LIFO to FIFO change for both Years 8 and 9:
Change in LIFO Reserve x (1- Tax rate) = [ $(46,000) - $(50,000) ] x (1 - .35) = $2,600 increase
c. The primary analysis objective when making a LIFO to FIFO restatement is to (1) achieve better comparability between
firms using different inventory methods, and (2) obtain better measures, using more recent costs, of the value of
inventory on the balance sheet.

a. Ending Inventory Adjusted from LIFO to FIFO:

At Jan. 29, 1999 (Year 9): = LIFO Inventory + LIFO Reserve = $219,686 + $26,900 = $246,586
At Jan. 30, 1998: (year 8) = LIFO Inventory + LIFO Reserve = $241,154 + $25,100 = $266,254
b. Net Income as Adjusted from LIFO to FIFO:
Year ended Jan. 29, 1999: = LIFO Income + After-Tax Change in LIFO Reserve.
= $31,185 + [ ($26,900 – $25,100) x (1 - .37) ] = $32,319
c. The primary analysis objective when making a LIFO to FIFO restatement is to (1) achieve better comparability
between firms using different inventory methods, and (2) obtain better measures, using more recent costs, of the
value of inventory on the balance sheet.
Straight-Line
Depreciation expense per year= (Cost- Salvage value)/ Useful life in periods
($000s) YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5
Earnings before taxes
& depreciation: $1,500.0 $2,000.0 $2,500.0 $3,000.0 $3,500.0
(a) Depreciation (200.0) (200.0) (200.0) (200.0) (200.0)
Net Before Taxes $1,300.0 $1,800.0 $2,300.0 $2,800.0 $3,300.0
(b) Income Taxes (650.0) (900.0) (1,150.0) (1,400.0) (1,650.0)
(c) Net Income $ 650.0 $ 900.0 $1,150.0 $1,400.0 $1,650.0
Depreciation 200.0 200.0 200.0 200.0 200.0
(d) Cash Flow $ 850.0 $1,100.0 $1,350.0 $1,600.0 $1,850.0

Sum-of-the-years'-digits
Depreciable amount = Total cost - Salvage value = 2,000,000
The sum of useful life = 10+9+8+7+6+5+4+3+2+1= 55
The Depreciation Factors: Year 1: 10/55 Year 2: 9 /55 Year 3: 8/55 Year 4: 7/55 Year 5: 6 /55
Ex: The depreciation expense of the first year = 2,000,000 x 10/55= 363,63
($000s) YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5
Earnings before taxes
& depreciation $1,500.0 $2,000.0 $2,500.0 $3,000.0 $3,500.0
(a) Depreciation (363.6) (327.3) (290.9) (254.5) (218.2)
Net Before Taxes $1,136.4 $1,672.7 $2,209.1 $2,745.5 $3,281.8
(b) Income Taxes (568.2) (836.4) (1,104.6) (1,372.8) (1,640.9)
(c) Net Income $ 568.2 $ 836.3 $1,104.5 $1,372.7 $1,640.9
Depreciation 363.6 327.3 290.9 254.5 218.2
(d) Cash Flow $ 931.8 $1,163.6 $1,395.4 $1,627.2 $1,859.1
Note: Vs. Straight-Line—Cash flow larger; Net Income smaller; Depreciation larger

Double-Declining-Balance
Straight- line depreciation rate = 100%/ useful life
Double- declining balance rate = 2 x straight-line depreciation rate
Depreciation expense= Double- declining balance rate x beginning period book value
Example (Year 1):
- Step 1: Straight- line depreciation rate = 100%/ 10= 0.1
- Step 2: Double- declining balance rate = 2 x 0.1= 0.2
- Step 3: Depreciation expense= 0.2 x 2,000,000= 400,000

($000s) YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5

Earnings before taxes
& depreciation: $1,500.0 $2,000.0 $2,500.0 $3,000.0 $3,500.0
(a) Depreciation (400.0) (320.0) (256.0) (204.8) (163.8)
Net Before Taxes $1,100.0 $1,680.0 $2,244.0 $2,795.2 $3,336.2
(b) Income Taxes (550.0) (840.0) (1,122.0) (1,397.6) (1,668.1)
(c) Net Income $ 550.0 $ 840.0 $1,122.0 $1,397.6 $1,668.1
Depreciation 400.0 320.0 256.0 204.8 163.8
(d) Cash Flow $ 950.0 $1,160.0 $1,378.0 $1,602.4 $1,831.9
Note: Cash flow higher than straight line*, lower than S.Y.D. (except Year 1).
Net income lower than straight line*, higher than S.Y.D. (except Year 1).
Depreciation higher than straight line*, lower than S.Y.D. (except Year 1).
*(except year 5)

a. Cash xxx
Gain on disposition* xxx
Net assets of discontinued operations xxx
* (A loss on disposition would be recorded as a debit)
b. Income (expense) related to discontinued operations include the operating profit (loss) recorded prior to sale and the gain
(loss) on sale. These are reported net of applicable tax.
c. When estimating future earning power, the results from discontinued operations should not be treated as recurring. This
is important for an assessment of the permanent income of a company.
d. Separately reporting discontinued operations allows the analyst to view the results of operations without the segment that
will not be ongoing. As a result, the analyst can better assess the permanent component of income, for which results of
discontinuing operations will be excluded.

a. Net income…………………………………………………….$1,000,000
Other comprehensive income
± Unrealized loss on marketable securities………………….($80,000)
± Foreign currency translation gain..….………………………50,000
± Post retirement benefit adjusment ………………………….(75,000)
± Unrealized holding loss in derivatives instruments………..(12,000)
Comprehensive income……………………………………….$883,000
b. Unrealized loss on marketable securities will affect the Other Comprehensive Income section of the Balance Sheet.
Foreign currency translation gain will affect the Other Comprehensive Income section of the Balance Sheet.
Post retirement benefit adjustment will affect the Pension Liabilities section of the Balance Sheet.
Unrealized holding loss in derivatives instruments will affect the Other Comprehensive Income section of the Balance
Sheet.
1. Basic earnings per share for Year 8 is: 2,000,000 + (2,000,000)*(9/12) = 2,150,000 shares ⇒ Option b is correct
2. For calculation of basic earnings per share only shares which are issued by the company i.e. outstanding shares of company are
considered. Dilutive securities such as convertible bonds, warrants, options, etc. are not considered. As warrants are dilutive
securities it would not be considered for calculation of basic earnings per share.
⇒ Option a is correct
3. Exercise price - $5
Average price - $4
Exercise price of warrants is more than the average price of share it is antidilutive. Hence these stock warrants are not
considered for calculation of diluted basic earnings. ⇒ Option a is correct

a. Computation of earnings components as a percent of sales

2011 2010 2009
Sales 100% 100% 100%
Cost of sales 42.7% 40.9% 41.2%
Selling, general, and administrative expenses 34.4% 34.8% 34.5%
Other (income) expense, net -0.1% 1.9% 0.7%
Interest expense, net 0.3% 0.4% 0.5%
Provision for income taxes 7.4% 7.2% 7.4%
Net income attributable to non-controlling interest 0.7% 0.7% 0.7%
Cost of sales has remained fairly steady in each of the 3 years as a percentage of sales. This has accounted for the consistent
level of pre-tax profits, as all other expense categories have also remained fairly constant across these years for Colgate.

b. Sales and cost of sales are typically the most highly persistent income statement items, and reductions in COS as a
percentage of sales are fairly rare in practice. SG&A costs are also typically highly persistent. However, the company
may be able to find ways to cut some of these through operating efficiencies. However, a decision to cut these types of
persistent expenses, along with expenses like R&D, can have severe ramifications for future profitability. Alternatively,
if Colgate engaged in significant restructuring, these costs are generally viewed as transitory.
c. Provision for taxes as a percent of earnings before income taxes:
FY 2011 = $1,235/$3,789 = 32.6%
FY 2010 = $1,117/$3,430 = 32.6%
FY 2009 = $1,141/$3,538 = 32.2%
Deviations from the statutory percentage of 35% commonly arise as a result of expenses that are recognized for financial
reporting purposes that are not deductible for tax purposes. An example is a restructuring charge that must be recognized
when incurred for financial reporting purposes, but cannot be deducted for tax purposes until paid.

d. Colgate reports $ 256 and $ 262 in expenses related to research and development in 2010 and 2011, respectively.
Advertising expenses are $ 1,656 and $ 1,734 for 2010 and 2011, respectively. Together these items represent 12% of net
sales for Colgate in each year. Amounts spent on R&D and advertising are investments by the company designed to
generate new profitable products and to improve sales of existing products. However, these investments are not recorded
as assets in the balance sheet. Instead, the full amounts spent on R&D and advertising by Colgate in 2010 and 2011 are
recognized as expenses in those years. The rationale for treating R&D and advertising amounts as expense rather than as
assets is due to the uncertain nature of the benefits that relate to investments in R&D and advertising.

e. Amounts spent on R&D and advertising benefit current and future periods. A company with low earnings in the current
period may be tempted to reduce the amount spent on R&D and/or advertising in order to limit the amount of expense
recognized. By lowering an expense, firms can increase net income in the current period. If analysts fail to recognize the
potentially negative impact on future earnings of these reductions in investment, then forecasts of future earnings will be
overly optimistic. This can lead to an over-valuation of the company

a. Gain on Sale = 600 - (860-300) = $ 40.

Of that 35% = $ 14 is a tax effect, which is reflected in the balance sheet as a deferred tax liability. The after tax gain
reported in the income statement is $ 26
b. As an analyst we should ignore the effects of the discontinued operation. That is because analysis is forward looking and
so we need to analyze the company's continuing divisions. Therefore, it is important to calculate ratios for the present
and past years for only continuing operations when doing trend analysis. In 2012, however it is important to exclude the
cash of $ 600 from assets, when determining ROA

\
a. Basic EPS= Net income/ Shares outstanding = $4 million/ $3 million = $1.33
Share purchased in open market =(Common shares x Share price)/ Average market value = 1,000,000 x 15 / 20 = 750,000
Additional shares = Common shares - Share purchased in open market = 1,000,000 - 750,000 = 250,000
Diluted EPS = Net income/ (Common shares outstanding + Additional shares) = 4,000,000 / 3,000,000 + 250,000 = $1.23
b. Basic EPS= Net income/ Common shares outstanding = 3,000,000/ 3,000,000 = $1
Shares purchased in open market = 1,000,000 x 15 / 18 = 833,333
Additional shares= 1,000,000 - 833,333 = 166,667
Diluted EPS = 3,000,000/ 3,000,000 + 166,667 = $0.95

a. The Year 11 CFO of Campbell is higher (by $403.7 million) than its Year 11 net income for two main reasons:
Some items decreased net income but did not use cash—specifically:
- Depreciation and amortization are expenses not requiring a cash outlay ($208.6).
- Deferred income taxes are an expense that has no present cash payment ($35.5).
- Several charges and expenses did not require outlays of cash ($63.2).
- A decrease in inventory implies that cost of sales are charged by reducing inventory levels rather than by making cash
payments of $48.7.
Some items generated operating cash inflow did not enter into the determination of net income—specifically:
- The decrease in accounts receivable means that cash is collected beyond the amounts recognized as sales revenue in the
income statement ($17.1).
- There are several other items that had a similar effect, amounting to $30.6.

a. Cash Flows from Operations Computation:

Net income $10,000
Add (deduct) items to convert to cash basis:
Depreciation, depletion, and amortization $8,000
Deferred income taxes 400
Amortization of bond discount 50
Increase in accounts payable 1,200
Decrease in inventories 850
10,500
$20,500
Deduct items to convert to cash basis:
Undistributed earnings of unconsolidated
subsidiaries and affiliates (200)
 Amortization of premium on bonds payable (60)
Increase in accounts receivable (900)
(1,160)
Cash provided by operations $19,340
b. (1) The issuance of treasury stock for employee stock plans (as compensation) requires an addback to net income
because it is an expense not using cash.
(2) The cash outflow for interest is not included in expense and must be included as cash outflow in investing activities
(as part of outlays for property.)
(3) If the difference between pension expense and actual funding is an accrued liability, the unpaid portion must be
added back to income as an expense not requiring cash. If the amount funded exceeds pension expense, then net income must
be reduced by that excess amount.
a. The two measures are summary performance metrics from two different statements (or portions of statements) that deal
with operations—the income statement and the cash from operations (CFO) section of the statement of cash flows. There
is considerable confusion among users of financial statements about both the concept of "operations" and about the
different aspects of operations that these two measures are designed to portray.
The function of the income statement is to measure the profitability of the enterprise for a given period. This is done by
recognizing revenue when earned, and then matching expenses with those revenues. Moreover, costs incurred during a
period that do not create future benefits must be charged to expense regardless of the availability of related revenues against
which they can be matched. While no other statement measures profitability as well as the income statement, it does not
show the timing of cash flows and the effect of operations on liquidity and solvency. Consequently, other specialized
statements are needed to focus on the latter factors, which are different dimensions of earning-related activities.
Cash from operations (CFO) encompasses the broader concept of operations compared with net income. It encompasses all
earning-related activities of the entity and it is concerned not only with revenues and expenses but also with the cash
demands of these activities such as investments in customer receivables and in inventories as well as the financing provided
by suppliers of goods and services. We can arrive at operating cash receipts and disbursements by adjusting net income for
items needed to convert it to the cash basis (indirect format). We must remember that CFO focuses on liquidity and is not a
measure of profitability as it excludes important costs such as the use of long-lived assets in operations, nor important
revenues such as equity in the earnings of nonconsolidated subsidiaries or affiliates.
b. Analysis of Transactions
1. Sales of marketable securities for cash at more than their carrying value.
2. Sale of merchandise with deferred payments (one-half within one year and one-half
after one year).
3. Reclassify noncurrent receivable as current receivable.
4. Payment of current portion of long-term debt. 5. Collection of an account receivable.
6. Recording the cost of goods sold. 7. Purchase of inventories on account (credit terms).
8. Accrual of sales commissions (to be paid at a later date).
9. Payment of accounts payable (resulting from purchase of inventory).
10. Provision for depreciation on a sales office.
11. Borrowing cash from a bank on a 90-day note payable.
12. Accrual of interest on a bank loan.
13. Sale of partially depreciated equipment for cash at less than its book value.
14. Flood damage to merchandise inventories (no insurance coverage).
15. Declaration and payment of a cash dividend on preferred stock.
16. Sale of merchandise on 90-day credit terms.
17. Provision for uncollectible accounts receivable.
18. Write-off of an uncollectible receivable.
19. Provision for income tax expense (to be paid the following month).
20. Provision for deferred income taxes (set up because depreciation for tax reporting
exceeded depreciation for financial reporting).
21. Purchase of a machine (fixed asset) for cash. 22. Payment of accrued salary expense to employees
a.

NOA = $4,000,000 + $2,000,000 = $6,000,000

NOPAT = NOA * RNOA = $6,000,000 * (10%) = $600,000
The net income for the first alternative is: $600,000 – ($1,000,000 * 12%)(1 – 0.4) = $528,000
The net income for the second alternative is: $600,000 – ($2,000,000 * 12%)(1 – 0.4) = $456,000
b. The ROCE for the first alternative is: $528,000/$5,000,000 = 10.56%
The ROCE for the second alternative is: $456,000/$4,000,000 = 11.40%
c. The assets-to-equity ratio for the first alternative is: $6,000,000/$5,000,000 = 1.2
The assets-to-equity ratio for the second alternative is: $6,000,000/$4,000,000 = 1.5
d. RNOA = $600,000/$6,000,000 = 10%
 The asset-to ratio in section c indicates that the second alternative is preferred because it uses more debt. In addition, with
the second alternative, shareholders would assume more risk, but calculations in ROCE show that the expected returns are
higher.

RNOA = 3 * (7%) = 21%

ROCE = RNOA + (LEV x Spread) = 21% + (1.667)(8.4%) = 35.0028%
Leverage advantage to common equity:
RNOA 21%
Leverage advantage 14%
ROCE 35%

a. With debt: ROCE = $157,500 / $1,125,000 = 14%.

In the absence of leverage, the noncurrent liabilities would be substituted with equity. Accordingly, there would be no
interest expense with all-equity financing.

Net income (with leverage) $157,500

Plus interest saved ($675,000 8%) $54,000
Less tax effect of interest expense 27,000 27,000
Net income (without leverage) $184,500

Without debt: ROCE without leverage = $184,500 / $1,800,000 = 10.25%.

This means that leverage is beneficial to Rose's shareholders when ROCE with leverage.
b. NOPAT = $157,500 + [$675,000 x 8% x (1-.50)] = $184,500
RNOA = $184,500 / ($2,000,000-$200,000) = 10.25%
c. The company is using borrowed funds in its capital structure. Since the ROCE is greater than RNOA, the use of financial
leverage is beneficial to stockholders. Specifically, the after cost of debt is 4% and the financial leverage (NFO/Equity)
is $675,000 / $1,125,000 = 60%.
Therefore, ROCE = RNOA + LEV x Spread = 10.25% + 0.60 x (10.25% - 4%) = 14%, as before.
The favorable effect of financial leverage is given by the term [0.60 x (10.25% - 4%)] = 3.75%.

a. (1) Quaker Oats does not reveal its computation of this return. Accordingly, we make some simple computations and
assumptions: (i) For simplicity, focus on one share, (ii) The dividend is $1.56 for Year 11, (iii) The average stock price is
$55 and the price increase for Year 11 is $14—based on the beginning price of $48 and the ending price of $62. Using
this information, we compute return to a share of stock as follows:
= [Dividend per share + Price increase per share] / Average price per share = [$1.56 + $14] / $55 = 28.3%
However, if we use the beginning price of $48 per share, we get closer to the company's 34% return:
= [$1.56 + $14] / $48 = 32.4%
2) The return on common equity is based on the relation between net income and the book value of the equity capital. In
contrast, Quaker Oats’ “return to shareholders” uses dividends plus market value change in relation to the market price per
share (cost of investment to shareholders.)

b. The company must have derived the 3.6% from price, market, and other factors that are not disclosed. Conceptually, this
3.6% should reflect the added risk of an investment in Quaker Oats’ stock vis-à-vis a risk-free security such as a U.S.
Treasury bond
c. Quaker does not reveal its computations. It may disclose a variety of interest rates on long-term debt that it carries in the
notes to financial statements. Based on data available to it, but not to the financial statement reader, it probably computed
a weighted-average interest rate from which it deducted the tax benefit in arriving at the 6.4% cost of debt.

a. Computation of Return on Invested Capital Measures:

As a first step, we construct the company’s income statement.
Sales (500,000 units @ $10). $5,000,000
Fixed costs 1,500,000
Variable costs (500,000 units @ $4). 2,000,000
Labor costs (20 employees x $35,000). 700,000
Income before taxes 800,000
Taxes (50% rate) 400,000
Net income $ 400,000
(1) RNOA = [$400,000 + ($2,000,000 x 7.5%)(1-0.50)] / ($8,000,000-$2,00,000) = $475,000 / $6,000,000 = 7.92%
(2) ROCE = [$400,000 - ($1,000,000 x 6%)] / $3,000,000 = 11.33%

b. Wage Rate Analysis to meet a Target Return on Invested Capital:

Estimated Fiscal Year 9 Operations:
Sales (550,000 units @ $10) $5,500,000
Fixed costs ($1,500,000 x 1.06) 1,590,000
Variable costs ($550,000 units @ $4) 2,200,000
Income before labor costs and taxes $1,710,000
To obtain a 10% return on long-term debt and equity capital, Zear will need a numerator of $600,000 given an invested
capital base of $6,000,000. The required operating income to yield this $600,000 amount is computed as:
Net income + Interest expense x (1 - 0.50) = $600,000
Net income + ($2,000,000 x 7.5%) x (1-0.50) = $600,000
Net income = $525,000
Assuming taxes at a 50% rate, Zear needs pre-tax income of $1,050,000, computed as:
Income before labor and taxes $1,710,000
Labor costs ?
Pre-tax income $1,050,000
This implies: Labor costs = $660,000 or Average wage per worker = $660,000 / 22 employees = $30,000 per employee
Since the current salary level is $35,000, Zear cannot achieve its target return level and give a salary raise to its employees.

Problem 8-3 (30 minutes)

a. ROCE = $1,650 / $3,860 = 42.7%

b. NOPAT = ($2,550 + $10) x (1-0.35) = $1,664

NOA = $7,250-$3,290 = $3,960
RNOA (using year-end NOA balance) = $1,664 / $3,960 = 42%

The effect of financial leverage, thus, is only 0.7% as NFO/NFE are insignificant. Most of Merck’s ROCE in this year is
derived from operating results.

Pre-tax income to sales 0.36

Net income to sales 0.23

Sales/current assets 1.47

Sales / fixed assets 2.97

Sales / total assets 0.98

Total liabilities / equity 0.88

L-T liabilities /
equity 0.03