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Chapter7Long-Term Debt-Paying AbilityPROBLEMSPROBLEM7-1Recurring Earnings,Excluding InterestExpense,Tax Expense,Equity Earnings,and MinorityEarnings----------------------------------------------------------------------------------------------------Times InteretsEarned=㊀，Interest ExpensIncludingCapitalized InterestEarningsbefore interestand tax:Net sales$1,079,143Cost ofsales792,755Selling andadministration264,566$21,822$21,822a.工㊀工㊀------------------------㊀㊀Timas ntst Earned==
5.06tim sper yar$4,311b.Cash basistimes interest earned:,=《$21,822+$4S6W2=.34imes peryear$4,311$4,311一一PROBLEM7-2Recurring EarningsExcluding InterestExpense,Tax Expense,Equity Earnings,a.Times InterestEarnedand MinorityEarnings二Interest Expense,Including$67560$735FeoCapitalized InterestIncome before income taxesPlus interestAdjusted incomeInterest expenseTimes Interest Earned=$735=
12.25times peryear$60Recurring EarningsExcluding InLeresLExpensezTax Expense,Equty Earnings,and Minorityb.,Earnings+Interest Portion of RentalsFixed Charge Coverage=Interest Expense,Including CapitalizedInterest+Interest Portionof Rentals$160,
0004.Debt to Tangible Net Worth=
86.5%TShareholders Equity-Intangible$196,000-$11,000$575,
000147.4%$410,000-$20,000b.No,Barker Company has atimes interest earned of
5.3times whilethe industryaverageis
7.2times.This indicatesthat Barker Companyhasless than average coverageof itsinterest.Also,BarkerCompanyhas amuch higherthanaveragedebt/equity,and debttotangible net worth ratio.c.Allen Companyhas abetter times interest earned,debt ratio,debt/equity,and debttotangible net worth.PROBLEM7-10a.
1.Times Interest Earned=2004:$280,000-$156,000=
7.29times peryear$17,000=
9.06times peryear2003:$302,000-$157,000$16,
0008.80times peryear2002:$286,000-$154,000二$15,000=
8.28times peryear2001:$270,000-$150,000$14,500=
4.39times peryear2000:$248,000-$147,000$23,000Recurring Earnings,ExcludingInterest,Tax Expense,Equity Earnings,and MinorityEarnings+
2.Fixed ChargeCoverage Interest Portionof Rentals Interest Expense,二Including CapitalizedInterest+Interest PortionofRentals2004:$280,000-$156,000+$10,000=
4.96times peryear$17,000+$10,0002003:$302,000-$157,000+$9,000=
6.16times peryear$16,000+$9,0002002:$286,000-$154,000+$9,500=
5.78times peryear$15,000+$9,5002001:$270,000-$150,000+$10,000=
5.31times peryear$14,500+$10,000$248,000-$147,000+$9,000=
3.44times peryear$23,2000:000+$9,
0003.Debt Ratio=Total LiabilitiesTotal Assets2004:$88,000+$170,000=
46.07%$560,0002003:$89,500+$168,
00046.48%二$554,0002002:$90,500+$165,000=
46.14%$553,8002001:$90,000+$164,
00046.31%$548,500二2000:$91,500+$262,000=
65.83%$537,
0004.Debt/Equity=Total LiabilitiesShareholders Equity2004:$88,000+$170,000=
85.43%$302,0002003:$89,500+$168,000=
86.85%$296,5002002:$90,500+$165,000=
85.65%$298,3002001:$90,000+$164,
00086.25%二$294,5002000:$91,500+$262,000=
192.64%$183,
5005.Debt toTangible Net Worth=Total LiabilitiesShareholders Equity-Intangible Assets$88,000+$170,0002004:=
91.49%$302,000-$20,0002003:$89,500+$168,
00092.46%二$296,500-$18,0002002:$90,500+$165,000=
90.83%$298,300-$17,
00091.20%2001:$90,000+$164,000二$294,500-$16,000=
209.79%2000:$91,500+$262,000$183,500-$15,000b.Both thetimesinterest earned and the fixed charge coverageare good.The timesinterestearned issubstantially betterthan thefixed chargecoverage becauseof theoperating leases.Both of these ratiosmaterially declinedin
2004.The debt ratio,debt/equity,and debtto tangiblenet worthmaterially improvedbetween2000and
2001.During theperiod2001-2004,these ratioswere relativelysteady andappearedto begood.The debtto tangiblenet worthratio isnot asgood as the debt/equity ratiobecauseof theinfluence ofintangibles.Adjusted income from part a1/3of operatinglease$735payments1/3x$150Adjusted income,including rentals50$785Interest expense1/3of operatinglease payments$6050$110Fixed ChargeCoverage=$785=
7.14times peryear$110PROBLEM7-3Recurring Earnings,Excluding Interest Expense,Tax Expense,Equity Earning,a.Times InterestEarned=and MinorityEarningsInterest Expense,Including CapitalizedInterestIncomebeforeincome taxesandextraordinary charges$36Plus interest161Adjusted income522Interest expense$16Times InterestEarned:1divided by2=
3.25times peryearRecurring Earnings,Excluding InterestExpense,Tax Expense,Equity Earnings,and MinorityEarnings+InterestPortionb.FixedChargeCoverage=Of Rentals________________________________________________________________________InterestExpense,Including CapitalizedInterest+InterestPortion OfRentalsAdjusted incomeparta$521/3of operatinglease payments1/3x$60201Adjustedincome,including rentals$72Interest expense$161/3of operatinglease payments202Adjusted interest expense$36Fixed chargecoverage:1divided by2=
2.00times peryear一a.Debt RatioTotal Liabilities$174,979“二---------------------------------------------------------==
41.2%Total Assets$424,
201.....Total Liabilities$174,979ccn u/r Db.Debt/Equity Ratio=-------------------------------------=-------------=
70.2%c.Ratio ofTotal Debt toTangible NetWorth=㊀Stockholci rsEquity$249,222Total Liabilities=$174,979$174,979=
70.9%二Tangible NetWorth$249,222-$2,324$246,898d.Kaufman Companyhas financedover41%of itsassets by the useof fundsfrom outsidecreditors.The Debt/Equity Ratioand the Debt toTangible NetWorth Ratioare over70%.Whether theseratiosare reasonabledepends uponthe stabilityof earnings.PROBLEM7-5RatioTimes TotalDebt/Debt Debt/Interest TangibleTransactionRatio EquityEarnedNet Wortha.Purchase ofbuildings financed by—++十mortgageb.Purchase inventoryon short-term一+++loanc.Declaration andpayment ofcash+++0dividendd.Declaration andpayment ofstock0000dividende.Firm increasesprofits bycutting+cost ofsalesf.Appropriation ofretained earnings0000g.Sale ofcommon stock0h.Repayment oflong-term bankloan+i.Conversion ofbonds to common stockj.Sale ofinventory atgreater than+———cost+a.Times InterestEarned:Times interest earned relatesearnings beforeinterest expense,tax,minority earnings,andequity income to interestexpense.The higherthis ratio,the betterthe interestcoverage.The timesinterest earnedhas improvedmaterially instrengthening the long-term debtposition.Considering that the debtratio andthe debtto tangiblenet worthhave remainedfairlyconstant,the probablereason for the improvementis anincrease inprofits.The timesinterest earnedonly indicatesthe interestcoverage.It islimited in that itdoes not considerother possiblefixed charges,and itdoesnotindicate the proportion ofthe firms resourcesthat havecomefromdebt.Debt Ratio:The debtratio relatesthe totalliabilities to the total assets.The lowerthis ratio,the lowerthe proportion of assetsthat have been financedby creditors.For Arodex Company,this ratiohas beensteady for the past three years.This ratio indicatesthat about40%of thetotalassets havebeen financedby creditors.For most firms,a40%debtratiowould be considered to be reasonable.The debtratio islimited inthat itrelates liabilities to thebook valueof totalassets.Many assetswould havea valuegreater thanbook value.This tendsto overstatethe debtratio and,therefore,usually resultsin aconservative ratio.The debtratio doesnotconsider immediate profitability and,therefore,can bemisleading asto thefirm sabilityto handle long-term debt.Debt toTangible NetWorth:The debtto tangiblenet worthrelates totalliabilitiestoshareholders，equity lessintangibleassets.The lowerthis ratio,the lowertheproportionof tangibleassets thathasbeenfinancedbycreditors.Arodex Companyhas hada stableratio ofapproximately81%for thepastthreeyears.Thisindicates thatcreditors havefinanced81%as muchasthe shareholders aftereliminatingintangibles fromtheshareholderscontribution formostfirms,this wouldbeconsidered一一tobe reasonable.The debtto tangiblenet worthratio ismore conservativethan the debtratio becauseof theelimination ofintangible items.It is also conservativeforthe samereason that the debtratio wasconservative,inthatbook valueis usedfortheassets andmanyassetshavea valuegreater thanbook value.The debtto tangiblenetworthratio alsodoesnot considerimmediateprofitabilityand,therefore,can bemisleading asto thefirmsability tohandlelong-term debt.Collective inferencesone maydraw fromthe ratiosof Arodex,Company:Overall itappears thatArodex Companyhas areasonable and improving long-term debtposition.The debtratioandthe debtto tangiblenetworthratios indicatethattheproportionofdebtappears tobe reasonable.The timesinterestearnedappears tobereasonableandimproving.The stabilityof earningsand comparisonwith industryratios willbe importantin reachingaconclusion onthelong-term debtposition ofArodexCompany.b.Ratios arebased onpast data.The futureis whatis important,and uncertaintiesof thefuturecannot beaccurately determinedby ratiosbased uponpast data.Ratios provideonly oneaspect ofa firmslong-term debt-paying ability.Other information,such asinformation aboutmanagement andproducts,isalsoimportant.A comparisonof thisfirm，s ratioswith ratiosof otherfirms in thesameindustry wouldbe helpfulinorder todecide ifthe ratiosare reasonable.PROBLEM7-7Recurring Earnings,Excluding Interesta.
1.Times InterestExpense,Tax Expense,Equity Earnings,Earned=and MinorityEarnings_____InterestExpense,Including CapitalizedInterest$162,000=
8.1times peryear$20,
0002.Debt Ratio=Total LiabilitiesTotal Assets$193,000=
32.2%$600,
0003.Debt/Equity RatioTotal LiabilitiesStockholders Equity二$193,000=
47.4%
4.Debt toTangible NetWorth Ratio=Total LiabilitiesTangibleNet Worth$193,000=
49.9%$407,000-$20,000b.New assetstructure forall plans:AssetsCurrent assets$226,000Property,plant,andequipment554,000Intangibles20,000Total assets$800,000Liabilities andEquityPlan ACurrentLiabilities$93,000$200,000,000/100=Long-term debtPreferred100,0002,000,000sharesstock250,000Common equity357,000No change in netincome$800,000Plan BCurrentliabilities$93,000$200,000,000/10=Long-term debtPreferred100,00020,000,000sharesstock Commonstock50,000Premium oncommon stock120,000Retained earnings300,000137,000No changein netincomePlan C$800,000Current liabilitiesLong-term debtPreferred$93,000Operating Income$162,000stock300,000Interest expense52,000*Common equity50,000110,000357,000Taxes40%44,000$800,000Net Income$66,000*$20,000+16%$200,000=$52,
0001.Recurring Earnings,Excluding InterestExpense,TaxExpense,Equity Earnings,and MinorityEarningsTimes InterestInterestExpense,Including CapitalizedInterestEarned=Plan A Plan B Plan C$162,000二
8.1$162,
0008.1$162,
0003.1times times$20,000—times$20,000$52,
0002.Debt=Total LiabilitiesRatioTotal AssetsPlan A Plan B Plan C$193,=241%$193,0=241%$393,00=491%$800,000$800,000$800,
0003.Debt/Equity Ratio=Total LiabilitiesPlanAPlanBPlanC!Stockholders Equity》》$193,000_$193,000_$393,000—o_L•o6—o_L•o6oo oo$607,000$607,000$407,
00096.6%Total Liabilities
4.Debt toTangible NetWorth=---------------------------------------PlanAPlanBPlanC$193,000$193,000$393,
00032.9%=329%
101.6%$607,000-$20,000$607,000-$20,000$407,000-$20,000Tangible NetWorthc.Preferred StockAlternative:Advantages:
1.Lesser dropin earningsper sharethan underthe common stock alternative.
2.Not theabsolute reductionin earningsthat accompaniedthe debtalternative.
3.There wouldbe animprovement inthe Debt Ratio,Debt/Equity Ratio,and TotalDebt toTangibleNetWorth Ratio.
4.Does nothave thereduced timesinterestearnedthat accompaniedalternative ofissuinglong-term debt.Disadvantages:
1.An increase inthefixed preferreddividend chargethatthefirm mustpay beforeanydividends canbe paidtocommonstockholders.Common StockAlternative:Advantages:
1.No increasein fixedobligations.
2.There wouldbe animprovement inthe DebtRatio,Debt/Equity Ratio,andtheTotal DebttoTangibleNetWorthRatio.
3.Not theabsolute reductionin earningsthat accompaniedthedebtalternative.
4.Does nothave thereduced timesinterestearnedthat accompaniedalternative ofissuinglong-term debt.Disadvantages:
1.Maximum dilutionin earningsper shareofthethree alternatives.Long-Term BondsAlternative:Advantages:
1.Higher earningsper sharethan withcommonstock.Disadvantages:
2.Material declinein Times InterestEarned.
3.A materialincreaseintheDebtRatio,Debt/Equity Ratio,and TotalDebttoTangibleNet WorthRatio.
4.Absolute reductionin earnings.
5.Increase inthe interestfixedchargethat mustbe paid.d.The10%preferred stockincreased thepreferred dividendswhich arenot tax deductible;therefore,the costof thesefunds isthe10%amount.The16%bonds aretaxdeductibleand,therefore,the after-tax costis
9.6%16%x1-.
40.Note toInstructor:You maywant totake thisopportunity topoint outtothestudents thatthealternative thatshould beselected isgreatly influencedbythechangeinearnings andthespecific debtstructure.The conclusionsin thisproblem wouldnot necessarilybe truewithchanged assumptions.Expense,Tax Expense,Equitya.TimesInterestEarned=Earnings and Minority EarningsrInterestExpense IncludingCapitalized InteresEarnings from continuingoperations beforeincometaxesand equityearnings1Add backinterestexpense1$74,780,0002Adjusted earnings2$37,646,000$112,426,000Times interestearned:[2divided by1]
1.99timesper yearb.Earningsfromcontinuing operationsPlus:1Interest$65,135,000Income taxes37,394,0002Adjusted earnings$140,175,000Times interestearned:[2divided by1]
3.72times peryearc.Removing equityearnings givesa moreconservative timesinterestearnedratio.The equityincomeis usuallysubstantially morethan thecash dividendreceived fromthe relatedinvestments.Therefore,thefirmcannot dependon thisincometocover interestpayments.Recurring Earnings,Excluding InterestExpense,Tax Expense,Equity Earnings,a.
1.TimesInterestEarned=andMinorityEarningsInterest Expense,IncludingCapitalized InterestPROBLEM7-9$95,000仁l.$170,000「-.-----------------------------------------------------=
9.5times=
5.3times$10,000-----------------------------------------------------$32,000oi...Total Liabilitiffi$160,000……$575,0000…n D----------------------------------------------------------------------
2.DebtRatio===
44.9%=
58.4%Shareholders*Equity$356,000$985,000n入,口・,Total Liabiliti®$160,000…$575,000Q------------------------------------------------------------------------------
3.Debt Equity===81*6%=
140.251ShareholdersEquity$196,000$410,000。
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