PRACTICE CASE A. "STEEL"' WHEELER 3 "Steel" Wheeler, your obnoxious classmate, was reading the Wall Street Journal the other day in the student lounge. He peered over the top of the paper and said, to no one in particular, "I see MegaTrump Co. just issued its 10 year, 10 percent bonds at 12%. As you know, this will yield them a premium, indicating that the market thinks they are a solid bet in the future. It's a good deal for them, too, because their interest expense will only be 10% while their competitors will have to borrow money in the bond market at the prevailing rate of 12%." Assignment In your most efficient style, avenge yourself for the embarrassment "Steel" caused you in last week's OB class by pointing out three serious misconceptions in his statement in front of the Student Association president, Stephanie Goodfund, who has just walked in with a cup of coffee. PRACTICE CASE B. PREY COMPANY, INC. Prey Company Inc.'s common shares were trading at $30 per share in January 2013. The December 31, 2012 balance sheet of Prey Inc. included the following Stockholders' Equity information: Net Income in 2012 amounted to $15,200,000 Assignment 1. Compute Prey Inc.'s book value per common share. 2. Prey Company uses LIFO in accounting for its inventories, and also uses accelerated depreciation methods. Would the book value of common shares have been higher, lower or unaffected if it had used FIFO and straight line depreciation instead? Explain. 3. Compute Prey's earnings per common share in 2012. What is the price-earnings ratio in January 2013? Calculations for year 2 : Payment to bond holders (based on coupon rate) $80,000 Effective interest expense for the year (basedonbookvalueofbonds)Annualamortizationamountforpremium.06$1,135,820=$68,149$80,000$68,149=$11,851 The year 2 entries to the T accounts would be as follows (in bold-faced type): CHAPTER 6 PRACTICE CASE A. 'STEEL' WHEELER4 Cheeses, Steeler old boy, bonds with a coupon rate of 10 percent, issued when the market rate is 12 percent, would be issued at a discount, not a premium. Besides, premiums or discounts do not directly reflect the market's valuation of the future prospects of the company, but rather the relationship between the coupon rate on the bonds and the rate the market requires. Finally, since the market will discount the bonds, they will cost the company the market rate of interest (in this case 12 percent). This is always the case. Isn't that right, Stephanie? CHAPTER 6 PRACTICE CASE B. PREY COMPANY, INC. 5 1. Book value per common share = Common stockholders' equity No. of common shares outstanding. Of the $42,200,000 in shareholder's equity, $10,000,000 is preferred. Therefore, common shares total $32,200,000. Book value per common share is $17.89($32,200,0001,800,000) 2. FIFO and straight line depreciation would generally result in higher assets and higher stockholders' equity, so higher book value per common share. 3. The preferred dividend is $80,000($10,000.08). Common shares issued =1,800,000(2,000,000 200,000 in treasury stock). Earnings per common share = (Net income - preferred dividend ) Average number of common shares outstanding. That would be $8[(15,200,000800,000)1,800,000] Price-Earnings ratio = Market price EPS =3.75(308)
