Analysis and Use of Financial Statements w solutionsch16.docx
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Analysis and Use of Financial Statements w solutionsch16.docx
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AnalysisandUseofFinancialStatementswsolutionsch16
Chapter16-Solutions
Overview:
ProblemLengthProblem#s
{S}1-4,7-9
{M}10
1.{S}a.Becausetheirstatedinterestrateremainedconstantat6.5%onboth12/31/00and12/31/01,theNotesdue8/12/02mustbethefixedratenotes.ThestatedinterestrateontheNotesdue5/01/02was6.81%at12/31/00,butitdeclinedto1.88%at12/31/01–thosemustbethevariablerateobligations.
b.Thedifferencebetweenthestatedandtheeffectiverateonavariablerateobligationmayresultfromaninterestrateswapbasedondifferentindices.AXPmusthaveswappedthevariablerateobligationbasedononeunderlying,e.g.,LIBOR,foraratebasedonadifferentindex,e.g.,theFederalFundsrate.
c.
Amountsin$millions
Effective
Years
Notesdue
Balance
Interest
Interest
Ended
Outstanding
Rate
Expense
a
B
c
bxc
12/31/2000
8/12/2002
$400
6.83%
$27.32
5/01/2002
400
6.90%
27.60
Total
$54.92
12/31/2001
8/12/2002
411
6.43%
26.43
5/01/2002
400
1.88%
7.52
Total
$33.95
Theinterestexpenseforeachnoteforeachyeariscomputedbymultiplyingtheprincipalamountofthenotebytheeffectiveinterestrate.
Interestexpensebasedonthestatedrates(assumingnoswaps)iscomputedinthetableonthefollowingpage.
Amountsin$millions
Stated
Years
Notesdue
Balance
Interest
Interest
Ended
Outstanding
Rate
Expense
a
b
c
bxc
12/31/00
8/12/02
$400
6.50%
$26.00
5/01/02
400
6.81%
27.24
Total
$53.24
12/31/01
8/12/02
411
6.50%
26.72
5/01/02
400
1.88%
7.52
Total
$34.24
Comparinginterestexpensefromthesetwotablesforbothyears,wecomputetheeffectoftheswapsoninterestexpenseforbothyears:
EffectofSwap
Year
$millions
%∆
2000
$1.68
3.2%
2001
(0.29)
-0.8%
Theeffectoftheswapswastoincrease2000interestexpenseby$1.68millionor3.2%.In2001,theswapsdecreasedinterestexpenseby$.29millionorlessthan1%.WhiletheswapsmayhaveprovidedAXPwithprotectionagainstsomepossibleinterestratechanges,theyhadanimmaterialeffectoninterestexpensein2000and2001.
d.Bothswapsweremostlikelyintendedtolowertheexposuretochanginginterestrates.BecauseAXPexpectedlowerrates,thefixedratenoteswereswappedintovariablerates;theswapincreased2000interestexpense(theeffectiveratewashigherthanthestatedrate)butreducedinterestexpensein2001(theeffectiveratewaslowerthanthestatedrate).
Theunderlying(indexonwhichtheeffectiverateswerecalculated)waschangedonthevariablerateobligations;AXPmusthaveexpectedadeclineinratesbasedonthenewunderlyingindex.However,theswapincrease2000interestexpenseasthecompanypaid6.90%onobligationswithastatedrateof6.81%.Therewasnodifferenceinratesat12/31/01.
2.{S}a.PepsiColikelywantedtoreducefinancingcostsbyreplacingfixedratedebtwithvariableratedebtwithlowerinterestrates.
b.Thenotionalamountsoftheswapsmusthavedeclinedbecausetheamountofthefixedratedebtdeclined.AnotherpossiblereasonforthelowernotionalamountsoftheswapsisadeclineinthedurationofPepsiCodebt.
c.Thefairvalueofaninterestrateswapismeasuredasthepresentvalueoftheexpectednetpaymentsontheswap,basedoninterestratesineffectateachmeasurementdate(seebox10-1ontextpages334-5).
OnDecember312000,thecompanyreportedthatitreceivedanaveragerateof4.4%onitsswapscomparedtoanaveragepayrateof4.9%.Despitethenegativespread,theswapshadanetpositivefairvalue,equaltothepresentvalueofthenetamountsexpectedbyPepsiCo.
OnDecember312001,thecompanyreportedanaveragereceiverateof5.6%onitsswapscomparedtoanaveragepayrateof1.7%.ThereportedpositivefairvaluereflectsthedeclineinvariableratesfromDecember31,2000,increasingthepresentvalueofthenetamountsexpectedbyPepsiCo.
d.
PepsiCo
(Amountsin$millions)
Effect
WeightedAverage
on
Notional
Receive
Pay
Interest
Amounts
Rate
Rate
Difference
Expense
Date
a
b
c
d=c-b
e=aXd
12/31/2000
$1,335
4.40%
4.90%
0.50%
$6.68
12/31/2001
1,077
5.60%
1.70%
-3.90%
(42.00)
Theswapsincreased2000interestexpenseby$6.68millionbutdecreased2001expenseby$42.00million.
e.Interestrateswapsthathedgefixed-rateobligationsarefairvaluehedgesunderSFAS133(seetextpage600).Thereforetheswaps(aswellastheunderlyingdebt)mustbemarkedtomarketquarterlyandthenoneffectiveportionofthehedgereportedasincome.Thefairvalueoftheswapsmustbereportedasanassetorliabilityonthebalancesheet.[NotethattheseexamplespredatetheadoptionofSFAS133.HoweveronDecember312000(2001),PepsiCoreportedthefairvalueoftheinterestrateswapsintheamountof$12($32)millionasacomponentofprepaidexpensesandothercurrentassets.Thefairvalueoftheswaps(thepresentvalueoftheexpectednetreceipts)isreportedasaprepaidexpensebecauseitrepresentstheexpectedreductioninfutureinterestpayments.]
f.TheswapsallowedPepsiCotoachieveitsgoaloflowerborrowingcostsin2001asshowninanswere.The2000impactwasslightlyadverse.
3.{S}a.PepsiCousesfixed-pricepurchaseorders,futures,swaps,andoptionstomanagecommoditypricerisk.Generally,thesetypesofderivativecontractsshouldbetreatedascashflowhedges.Atinceptionandoneachfinancialstatementdate,thesehedgesmustbemarkedtomarketandrecordedasassetsorliabilities.Theeffectiveportionofanygainorlossisreportedasacomponentofothercomprehensiveincome.Whentheunderlyingcommoditiesarepurchased,therealizedgainorlossmustbereportedasacomponentofcostofgoodssold.
b.Forwardcommitmentstopurchasegoodsandservicesusedintheproductionofitsproductsmustbereportedinthefootnotesonlywhentheyaretake-or-paycontractsthatmeettherequirementofSFAS47(seetextpage377).Theywouldbeneitherrecognizedinthefinancialstatementsnormarkedtomarketbecausesuchcontractsqualifyforthenormalpurchasesandnormalsalesexemption(seeBox16-2,textpage598).
Whentheunderlyinggoodsandservicesarepurchased,thecontractpriceisreportedontheincomestatementasacomponentofcostofgoodssoldorselling,general,andadministrativeexpenses.Anygainorlossongoods(services)isimplicitlyreportedaspartofgrossmargin(operatingmargin)atthetimeoutputissold.
c.Toevaluatepotentialgainsandlossesonfirmcommitmentsandpurchasecontracts,wewouldneedthefollowing:
i.Fairvaluesofthecommitmentsorcontracts,ifavailable.
ii.ThetermsofPepsiCocontracts(quantities,prices,anddates)andthepriceatwhichitwouldbeabletopurchasethecontractedamountsinthemarketplace(i.e.,thespotpriceofthecontract).ThedifferencebetweenspotandcontractpriceswouldenabletheanalysttoestablishwhetherthecontractswillincreaseordecreaseCOGS(andthereforegrossmargin)whentherelatedoutputsaresold.
iii.Forservices,thedifferencebetweencontractpriceandthecostofthesameservices(e.g.transportation)atcurrentpriceswouldenabletheanalysttodeterminetheeffectofthecontractsonoperatingmargins.Itwouldalsohelpdeterminewhetherchangesinselling,general,andadministrativeexpenseshavebeenaffectedbythosecontracts.
4.{S}a.Kemetwasexposedtoincreasingpricesfromalimitednumberofsuppliers.Thecompanymusthaveusedthepurchasecontracttofixthepriceitwouldpayandensureavailabilityoftheamountoftantalumrequiredtomeetoperatingneeds.
b.Althoughthepurchasecontractisaderivative,itisnottreatedassuchforfinancialreportingpurposesbecauseitqualifiesforthenormalpurchasesandnormalsalesexemption(seeBox16-2,textpage598).U.S.GAAPpermitsthisexceptionundertherebuttablepresumptionthatthepurchasecontractappliestocommoditiesthatwillbeusedintheproductionprocessandthecompanywilltakephysicaldeliveryofthecommodity.
c.Kemetdisclosesthepurchasecontractasacommitment,statingthegrossamountsithascontractedtopay($2billion)andthetermoverwhichthepaymentswillbemade(5years).Thereisnofinancialstatementrecognitionwhenthecontractisenteredinto.
d.Weneedthefairvalueofthesecontractstodeterminetheunrealizedgainorlossonthesecontracts.Thisgainorlossshouldbeaddedordeductedfromreportedearningstomeasuretheperformanceofthemanagement.
Alternatively,weneedthecontractamountsandprice,andthespotpriceoftantalumfor2002todeterminetheeffectofthecontractonreportedCOGS,grossmargin,andnetincome.For2003weneedthecontractamountsandprices,aswellasmarketpricestoestimatethosesameeffectsin2003.
TotheextentthatKemetexercisesthecommitmenttopurchasetantalumin2003,therealizedgainorlosswouldbereportedasacomponentofcostofgoodssoldwhenthegoodscontainingthetantalumaresold.Separatedisclosureofthatamountwouldfacilitateevaluationofmanagementperformance.
e.Alternatively,Kemetcouldhavepurchasedoptionstopurchasetherequiredamountoftantalum.TheadvantageisthatKemetwouldnothavecommittedtopurchaseaspecifiedamountoftantalumgivenadversepricechangesandwouldhaveremainedfreetoexercisetheoptiononlyifagaincouldberealized.Ineffect,optionsrequiresignificantlylowerinvestmentsrelativetofirmpurchasecommitments.
Onedisadvantage
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