Capital Lease Accounting Overview

Questions and Answers

What is capital lease accounting?

Capital lease accounting records the leased item as an asset and a corresponding leasehold liability on the balance sheet.

A firm with a capital lease will have lower asset turnover ratio compared to a firm with an operating lease.

True

In the early years of a capital lease, what will be lower in comparison to an operating lease?

Net income (correct)

Operating income

Cash flow

Return on assets (correct)

Which TWO statements are TRUE regarding a restructuring involving a $25,000,000 write-off of inventory and $35,000,000 in severance packages?

Net worth is reduced by $60,000,000. Signup and view all the answers

What impact does decreased depreciation expense have on operating cash flow?

It will decrease operating cash flow. Signup and view all the answers

When a company retires short-term notes payable using cash, what effect does this have on the current ratio?

Increase Signup and view all the answers

What will be the effect on the capital expenditures of chip makers as demand for computers declines?

Decrease Signup and view all the answers

In the sum-of-the-parts analysis, which concept is important?

Separate segments may be worth more individually than combined. Signup and view all the answers

What statements are TRUE regarding GAAP reporting and tax reporting during the early years of an asset's life?

Depreciation expenses are generally lower under GAAP. Signup and view all the answers

What indicates a company's return on invested capital?

Return on invested capital is measured by EBIT adjusted for taxes divided by total capital. Signup and view all the answers

Which effect do interest rates have when the supply of money decreases?

Interest rates rise. Signup and view all the answers

If Company A has lower net profit margin than Company B, what can be inferred?

Company A has lower revenues with identical net income. Signup and view all the answers

Which TWO of the following events will affect EPS and the P/E ratio if the price of common stock remains unchanged after the event?

Issuing debt to build an office complex Signup and view all the answers

Which TWO of the following choices are MOST important to discuss with the plant manager?

Supply chain bottlenecks Signup and view all the answers

What was the company's return on common equity for 20XX?

20.7% Signup and view all the answers

Under the percentage of completion method, first year's income is computed by multiplying the contract price by:

The ratio of first year's costs to estimated total costs Signup and view all the answers

What would be the effect on the debt/equity ratio and the current ratio if a company capitalizes a lease rather than treats the lease as an operating lease?

Increase....................Decrease Signup and view all the answers

Which of the following changes is LEAST likely to affect the valuation of a company using a discounted cash flow (DCF) model?

The company's common stock declines in value Signup and view all the answers

If one of the wholesalers of widgets leaves the industry, the price will:

Not change Signup and view all the answers

If the complementary industry is expected to grow by 6%, what is your estimate for product ABC sales?

3520 Signup and view all the answers

Which of the following choices would explain the difference in higher EV/EBITDA?

The U.S. company pays higher taxes Signup and view all the answers

What is the levered beta for this company?

1.79 Signup and view all the answers

If the company issues $1,000,000 preferred stock instead of bonds, it must increase its taxable income by what amount to provide the same after-tax income?

$98,485 Signup and view all the answers

If the industry increases the price for the product, which TWO of the following situations are TRUE?

For each 1% increase in price, there will be a 2% decrease in demand Signup and view all the answers

Which TWO of the following choices are MOST important to discuss with management about the widget?

Demand and pricing of the product Signup and view all the answers

Which of the following figures will change when a company pays a stock dividend?

EPS Signup and view all the answers

What is the Enterprise Value of PDQ at the beginning of the fiscal year?

$2,759 million Signup and view all the answers

In which of the following situations would an analyst use EV/Sales?

The company has negative cash flow Signup and view all the answers

Which components of the capital lease expense impact the operating cash flow statement?

A. I and III Signup and view all the answers

In order for a company to add value for its equity stakeholders, what must be true?

ROE must exceed the cost of equity Signup and view all the answers

All of the following are characteristics of a company that uses capital lease accounting rather than operating lease accounting, EXCEPT:

High net income in the early years of the lease Signup and view all the answers

Which statement is TRUE regarding two buyers' proposals for a British chocolate company?

The cash offer would not have exchange-rate risk for your client Signup and view all the answers

Which ratio is the best test of Binary, Inc.'s ability to meet its current obligations?

Quick asset ratio Signup and view all the answers

What is the exchange ratio if the target stock price is $94.58, offered $115 per share, with 80% stock?

1.051 Signup and view all the answers

What conclusion can be drawn if The Bear Company has been profitable for 20 years but has marginal cash flow?

It is an acceptable condition if the company has a significant amount of outstanding debt, which indicates positive operating cash flow Signup and view all the answers

Which TWO of the following events would be dilutive to the basic earnings per share of a company?

I. Stock splits Signup and view all the answers

Which of the items below could be a reason for a difference between income from continuing operations and net income?

Loss or gain on the sale of a business segment Signup and view all the answers

If the euro depreciated, which statement would be TRUE for an American company selling products in Spain?

The sales would translate into lower dollar amounts Signup and view all the answers

What happens to the terminal value of The Okemo Company if the rate on the T-bill decreases by 40 basis points?

Terminal value to increase Signup and view all the answers

How does GDP differ from GNP?

GNP includes U.S. expatriate production Signup and view all the answers

Study Notes

Effect on EPS and P/E Ratio

Issuing debt at a lower rate than WACC or purchasing debt below WACC can increase EPS and the P/E ratio.
Acquiring a company neutral to earnings does not affect EPS or P/E ratio with unchanged stock price.
Interest expenses from building capitalized assets do not immediately impact earnings.

Key Concerns for Plant Managers

Discussing supply chain bottlenecks and necessary components is crucial for production schedules.
Shortfalls in pension plans or product pricing are less relevant to the operational focus of plant management.

Return on Common Equity Calculation

ROE is calculated as net income divided by average common stockholders' equity.
$350 MM net income, $30 MM in dividends, and year-end equity of $1,850 MM gives an ROE of 20.7%.

Percentage of Completion Method

Income for the first year is computed by multiplying the contract price by the ratio of total costs incurred over estimated total costs.
This method ensures that expenses are deducted in the year they occur while recognizing income proportionally.

Impact of Capitalizing a Lease

Capitalizing a lease increases the debt/equity ratio due to added long-term debt.
Current liabilities increase leading to a decrease in the current ratio.

DCF Model Valuation Sensitivity

Terminal growth rate changes, interest rate fluctuations, and stock repurchases affect DCF model valuations.
A decline in the company's stock value has the least impact on company valuation through DCF.

Price Determinants in Competitive Markets

A loss of a wholesaler in a commodity-like market with low market share will not change product pricing.
Prices are driven by supply and demand dynamics since no single wholesaler has significant influence.

Regression Analysis for Sales Estimates

To estimate product sales based on the growth of a complementary industry, apply linear regression principles.
Calculating expected growth results in estimated product sales of 3520.

Explaining Differences in EV/EBITDA

Higher EV/EBITDA for a foreign company likely results from the U.S. company's higher effective tax rate.
Similar net incomes and margins suggest tax strategies impact profitability metrics.

Levered Beta Calculation

Levered beta, accounting for capital structure with debt, indicates a company’s risk relative to the market.
Formula applied to unlevered beta results in a levered beta of 1.79.

Taxable Income Adjustment for Preferred Stock

To match after-tax income when issuing preferred stock instead of bonds, taxable income must be adjusted upwards.
Mimicking bond interest expenses requires accounting for tax impacts, resulting in a needed taxable income increase of $98,485.

Elasticity and Revenue Implications

A coefficient of elasticity greater than 1 indicates that price increases will lead to larger decreases in demand, affecting revenues negatively.
Total revenue declines as demand reacts more significantly than price increases.

Key topics include capacity utilization and defect rates, as well as demand and pricing for the product.
Discussions around financials like share buybacks are broader and less relevant to immediate production concerns.

Share buybacks reduce the number of outstanding shares, boosting return on equity.
Book value per share declines if repurchases occur at a price higher than the current book value.

Stock Dividend Effects

Paying a stock dividend dilutes earnings per share (EPS), as net income is distributed over more shares.
Current assets, liabilities, and working capital remain unchanged by stock dividends.

Enterprise Value Calculation

Calculating the enterprise value involves accounting for long-term debt and equity, resulting in a value of approximately $2,759 million.

Use of EV/Sales Ratio

The EV/Sales ratio is applicable in assessing companies with negative cash flow, where DCF models are unreliable.
It permits comparisons regardless of differences in profit margins or financial structures.

Capital vs. Operating Lease Characteristics

Capital leases lead to higher operating income early on due to different expense recognition.
Companies utilizing capital lease accounting typically report lower return on assets and higher overall cash flow.

Corporate Restructuring Financial Impact

Significant financial restructuring actions include inventory write-offs and severance packages, which reshape the company's financial health and reporting.### Employee Layoffs and Financial Impact
Employees will be laid off next quarter, affecting financial statements.
Net worth (retained earnings) will decrease by $60 million and current liabilities will rise by $35 million due to severance wages payable.
Current assets will drop by $25 million because of reduced inventory value.
Working capital will decline by $60 million (Current Assets - Current Liabilities).
Operating cash flow remains unchanged despite these adjustments, as the cash flow effects offset each other.

Changes in Depreciation and Dividend Payments

A decrease in depreciation expense leads to a decrease in operating cash flow.
Declaring and paying cash dividends results in a decrease in retained earnings.
Depreciation affects cash flow calculations, illustrating its importance in financial reporting.

Current Ratio and Asset Turnover

Current ratio is initially 1.8; using cash to pay off short-term notes payable will improve the current ratio.
Asset turnover ratio will also increase as assets decrease with reduced liabilities.

Chip Makers and Financial Indicators

Manufacturing companies saw initial capital expenditures rise with increased demand for computers, followed by declines when demand fell.
A decline in demand would lead to lower capital expenditures as companies adjust to decreased sales.

Sum-of-the-Parts Analysis

This valuation method emphasizes that individual business segments may be more valuable if sold separately than combined.

GAAP vs Tax Reporting

In early asset life, companies often show lower depreciation on GAAP reports compared to tax reports, resulting in different earnings appearances.
Accelerated depreciation for tax can increase deferred tax liabilities, affecting financial perceptions.

Acquisition Pricing and EBITDA

Adjusted EBITDA multiple considers future synergies in acquisition offers.
Calculation involves multiplying existing EBITDA by the EBITDA multiple and then adjusting for synergies before calculating the implied multiple.

Return on Invested Capital (ROIC)

ROIC is calculated using EBIT adjusted for taxes, showcasing how effectively a company utilizes its capital.
A return of 23% indicates strong management of invested resources relative to the return generated.

Economic Implications for Oil Prices

Short-term demand declines will lower oil prices, but strong future growth in emerging markets can lead to higher long-term prices.

Corporate Financial Structuring

Operating cash flow in capital leases reflects both imputed interest and depreciation, impacting financial statements significantly.
For equity stakeholders, ensuring ROE exceeds the cost of equity is critical for value generation.

Evaluating M&A Offers

All-cash offers mitigate exchange-rate risk for the seller, making them attractive amidst currency fluctuations.
Quick asset ratio serves as a vital indicator of a company's ability to meet current obligations, crucial for manufacturers with irregular revenue streams.

Stock-Based Exchange Ratios

Calculating exchange ratios in M&A transactions includes evaluating stock prices, cash offers, and outstanding shares to understand the total financial implications for involved companies.### Exchange Ratio in Acquisitions
Exchange ratio is calculated by dividing the target company's offer price by the acquirer's stock price.
Example: $115 / $87.50 = 1.314.
Since only 80% of the transaction is financed by stock, the effective exchange ratio becomes 1.051 (1.314 x 0.80).

Bear Company Financial Analysis

Bear Company has been profitable for 20 years but has marginal cash flow.
Indicates that significant debt is acceptable if operating cash flow exceeds net income.
Operating cash flow is crucial for evaluating financial health, taking into account noncash expenses like depreciation and amortization.

Evaluation of Buyers' Proposals

Two European buyers for an American chocolate company; one offer is all cash, the other cash plus stock.
All-cash offer carries no exchange-rate risk for the American company.
Cash and stock offer values may increase with a rising euro and fluctuate with the acquirer's stock price.

Dilutive Events Impacting EPS

Stock splits and stock dividends increase the number of shares and result in lower earnings per share (EPS).
Reverse stock splits decrease the number of shares outstanding and may improve EPS.
Convertible bonds could dilute EPS on a fully diluted basis but impact basic EPS differently.

Income Measurement Differences

A difference between income from continuing operations and net income can be attributed to the loss or gain on the sale of a business segment.
Non-recurring items are recorded differently and do not cause discrepancies in calculating net income.

Impact of Euro Depreciation

A depreciated euro results in lower dollar amounts when converting sales to U.S. dollars.
It could potentially decrease sales volume in the long term due to higher costs for imported goods.

Hammer Court Company Valuation

The company's P/E ratio of 34 suggests it is a growth company since it trades at a substantial premium to the S&P 500 Index.
This premium indicates accelerated earnings growth compared to industry norms.

Residual Income as an Investment Metric

Residual income analysis is less appropriate when a company consistently pays dividends.
More effectively applied when estimating terminal values is challenging or in cases of negative operating cash flow.

Cash Flow Statement and Interest Payments

Both interest paid and interest received are recorded under "cash flow from operating activities."
Principal payments for debt reduce "cash flow from financing activities."

Swiss Franc Appreciation Expectations

Rising interest rates in Switzerland typically lead to an appreciation of the Swiss franc due to increased demand for its bonds.

Terminal Value and Discount Rates

Terminal value is likely to increase if the T-bill rate decreases, as this generally leads to a lower WACC.
Terminal multiples for a company may also rise because lower interest rates increase present values of future cash flows.

Differences Between GDP and GNP

Gross National Product (GNP) includes production by U.S. citizens abroad, while Gross Domestic Product (GDP) does not.
Both GDP and GNP exclude transfer payments such as social security.

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Description

Explore the nuances of capital lease accounting and its impact on financial ratios such as asset turnover and current ratios. This quiz delves into true statements related to restructuring and the effects of depreciation on operating cash flow. Test your understanding of these crucial accounting concepts.