Question X: Marketable Securities

BA 202A Reuven Lehavy Fall 1999 Franco Wong

Final Examination Thursday, December 9, 1999

Problem Points

1 12 2 16 3 12 4 13 5 8 6 12 7 7 8 10

Total 90

Write your answers in the space provided. Show all your work to receive partial credit

TO: BA202A FROM: R. Lehavy/ F. Wong RE: Posting of Final Grades

A new campus policy precludes me from posting (either physically or electronically) final course grades identified by Student ID #, unless each student on the list submits a signed waiver. By signing and dating below, you are giving me permission to post outside my office door or electronically in late-December your final course grade -- identified only by your Student ID #.

NAME (please print): ______

COHORT (circle one): Oski Axe Blue Gold

SIGNATURE: ______

DATE: ______

2 Question 1: Marketable Securities The InvestSec Corp. started operations on January 1, 1998. Selected balance sheet data as of the end of 1998 and 1999 and selected income statement data for its first two years of operations follow:

Balance Sheet 12/31/98 12/31/99

Assets Marketable securities $17,000 ?

Owners’ Equity Unrealized gain (loss) (3,000) 1,000 on marketable securities

Income Statement 1998 1999

Unrealized gain (loss) on $3,000 ? marketable securities

Realized gain (loss) on sale 1,000 ? of marketable securities

You are also given the following information about the firm’s marketable security purchases and sales during 1998 and 1999:

1. The firm purchased three marketable securities during 1998, A, B, and C. Securities A and B are trading securities, while security C is a security available for sale. Security A remained in the firm’s portfolio at the end of year 1998, at a market value of $12,000. Security C also remained in the firm’s portfolio at the end of year 1998, at a market value of $5,000. Security B was sold during the year, at a price of $8,000.

2. During year 1999 the firm did not purchase any additional marketable securities. It sold security A during the year, at a price of $14,000. Security C remained in the portfolio at the end of the year.

Required: a) What was the purchase price of security A?

3 Question 1 (...continued)

b) What was the purchase price of security B?

c) What was the purchase price of security C?

d) What was the balance in the Marketable Securities account on 12/31/99?

e) What was the amount of the unrealized gain (loss) on marketable securities on the firm’s income statement for 1999?

f) What was the amount of the realized gain (loss) on marketable securities on the firm’s income statement for 1999?

4 Question 2: Shareholders Equity Considering each of the following actions independently, state their effect on: (i) the firm's retained earnings and (ii) total owners' equity (assume that the firm's shares have a par value of $1 each).

a) Issue a stock dividend of 10% at the time that the firm's shares are selling in the market for $20/share. Before the dividend, there were 100,000 shares of stock outstanding.

b) Grant 1,000 stock options to executives at a time when the stock price was $15/share. The options have an exercise price of $15 each.

c) Executives exercise 400 options with an exercise price of $15 each at a time when the stock is selling for $20/share.

d) 4,000 shares of stock are repurchased for $18 each and are held as treasury stock.

5 Question 2 (...continued) e) 3,000 shares of treasury stock originally repurchased for $18 each are resold for $19 each.

f) 10,000 warrants with an exercise price of $25 are issued for $8 per warrant.

g) Declare and pay a cash dividend of $5,000.

h) Declare a 2-for-1 stock split. Before the split, there were 100,000 shares of stock outstanding. On that day, the stock is traded for $20 per share.

6 Question 3: Inventory Question

Below is information taken from the financial statements of eFIFO Co. and eLIFO Co. for the year ended December 31, 1998:

e FIFO Co. e LIFO Co.

Net Income 120,000 Net Income 135,000 Total Assets 700,000 Total Assets 640,000 Shareholders' Equity 500,000 Shareholders' Equity 320,000 Merchandise Inventory 12/31/97 69,000 Merchandise Inventory 12/31/97 84,000 Merchandise Inventory 12/31/98 62,000 Merchandise Inventory 12/31/98 88,000 Tax Rate 0% Tax Rate 0%

Additional Information: Additional Information: Inventories are computed using the periodic Inventories are computed using the periodic LIFO cost flow assumption. If the FIFO FIFO cost flow assumption. method of inventory valuation had been used instead of the LIFO method, merchandise inventory would have been greater by $9,000 at December 31, 1997, and $3,000 smaller at December 31, 1998.

Required: a. Compute eFIFO and eLIFO's return on equity (net income/shareholders' equity) for 1998.

7 Question 3 (...continued) b. Suppose that you are interested in comparing the performance of eFIFO to that of eLIFO. Using the information above, compute eLIFO's return on equity for 1998 if it had been using the FIFO method of inventory valuation instead of the LIFO method.

c. Suppose that on January 15, 1999 the following inventory valuation errors have been discovered for eFIFO Co.:

 The 12/31/1997 inventory was overstated by $8000  The 12/31/1998 inventory was understated by $1000 Compute eFIFO's return on equity for 1998 after correcting for the errors.

8 Question 4: Lease Question

The balance sheet as of December 31, 1999, for Taylor Laundry Inc. follows:

Assets Liabilities and Stockholders' Equity ______Current assets $10,000 Current liabilities $10,000 Noncurrent assets 60,000 Long-term liabilities 20,000 Stockholders' equity 40,000

Total liabilities and Total assets $70,000 stockholders' equity $70,000

The $20,000 of long-term debt on the balance sheet represents a long-term note that requires Taylor to maintain a debt/equity ratio of less than 1:1. If the covenant is violated, the company will be required to pay the entire principal of the note immediately. On January 1, 2000, Taylor entered into a lease agreement. The agreement provides the company with laundry equipment for five years for an annual rental fee of $5,000 (due at the end of each year). Round your answers to the nearest dollar.

Required: a. Compute Taylor's debt/equity (total liabilities to total shareholders' equity) ratio as of January 1, 2000, if the company treats the lease as an operating lease.

b. Compute the effects on Taylor's (i) assets, (ii) liability, and (iii) shareholders' equity accounts as of December 31, 2000, if the company treats the lease as an operating lease.

9 Question 4 (...continued) c. Compute Taylor's debt/equity ratio as of January 1, 2000, if the company treats the lease as a capital lease. Assume an effective interest rate of 12 percent.

d. Compute the effects on Taylor's (i) assets, (ii) liability, and (iii) shareholders' equity accounts as of December 31, 2000, if the company treats the lease as a capital lease. Assume an effective interest rate of 12 percent.

10 Question 5: Cash Flow Statement

Suppose that before you came to Haas, you were a financial manager at America Online, Inc. (AOL). Your boss, the CFO (who had never taken accounting before), had asked you to compute some cash flow measures. AOL’s accounting staff just finished AOL's 1999 income statement and balance sheet (see last two pages), but was still working on the cash flow statement. In addition to the income statement and balance sheet, they provided you with the following data: 1. Depreciation expense (of property and equipment) of $300 million are included in the Cost of Revenue, 2. All merger-related charges are non-cash expenses, and 3. Net capital expenditure (cash used – cash provided) amounted to $1,000 million.

Required: Compute AOL’s (a) operating cash flow and (b) free cash flow for the year ended June 30, 1999.

11 Question 6: Accounts Receivables

You were working late reviewing AOL’s trade accounts receivables. You had a few questions to ask the accounting folks, but they were all gone by 5 PM. Luckily, you found the following Note from the company’s 1999 preliminary financial statements (i.e., it had not been released to the public).

Excerpt from Note 2:

Trade Accounts Receivables. The carrying amount of the Company's trade accounts receivables approximate fair value. The Company recorded provisions of $33 and $25 million and write-offs of $x and $y million during the fiscal years ended June 30, 1999 and 1998, respectively.

Required: Use the information in the Note and the attached financial statements to answer the following questions.

(a) Assume that the accounting staff used the percentage of sales approach to estimate allowance for uncollectibles. What percentage point did they use to estimate bad debt expense for fiscal 1999? Assume that all of AOL's total revenues are on credit.

(b) What percentage of the gross trade accounts receivables at the end of fiscal 1999 is deemed uncollectible?

12 Question 6 (... continued)

(c) How much of the trade accounts receivables were written off in fiscal 1999?

(d) You wanted to "clean up" the balance sheet by writing off an additional $10 million of uncollectible accounts. However, you knew that your boss, the CFO, would not be happy if it would have an adverse impact on the company’s reported income and the tax bill. To find out if the CFO would like your idea, compute the effects of an additional $10 million write-off on the company’s:

(i) Total current assets,

(ii) Income from operations, and

(iii) Tax payment to the IRS (assume that AOL’s marginal tax rate was 40%).

13 Question 7: Capitalization vs. Expensing

Suppose your CFO boss was a true believer that AOL's subscriber acquisition costs have future benefits, and should therefore be capitalized and amortized over their useful life (instead of the current practice of immediate expensing). In fact, you can vividly recall his annoyance when AOL changed its accounting practice from capitalizing and amortizing to immediate expensing back in July 1, 1996. For the purposes of providing additional information to the security analysts, he asked you to compute the company’s fiscal 1999 income from operations as if it had never changed its accounting estimate on July 1, 1996 (as described below). Once again, the accounting folks had gone home and all you had were the attached financial statements and the following Note.

Excerpt from Note 2:

Subscriber Acquisition Costs and Advertising. The Company accounts for subscriber acquisition costs pursuant to Statement of Position 93-7, "Reporting on Advertising Costs" ("SOP 93-7"). As a result of the Company's change in accounting estimate, effective July 1, 1996, the Company began expensing all costs of advertising as incurred. Included in sales and marketing expense is both brand and acquisition advertising across the Company's multiple brands and was $599 million, $476 million and $453 million for the fiscal years ended June 30, 1999, 1998 and 1997, respectively.

Required: Compute AOL’s fiscal 1999 income from operations had AOL continued its practice of capitalizing and amortizing subscriber acquisition costs. Assume that: 1. Subscriber acquisition costs are always incurred on the first day of the fiscal year. 2. Capitalized costs are amortized over a period of two years, using the straight-line method. 3. Unamortized subscriber acquisition costs (reported under “Other Assets”) amounted to $314 million on June 30, 1996 (the end of fiscal 1996).

14 Question 8: Long-term Liabilities

Finally, the CFO asked you to review the company’s long-term liabilities, especially the convertible notes. He was concerned about the company’s ability to pay interest and the effect of future conversions on the company’s balance sheet. To prevent any potential problems, the CFO was considering buying back the entire outstanding convertible notes from the holders (at market prices). He asked you to help him form a decision. Once again, you picked up the financial statements and found Note 12 regarding the convertible notes (yes, the accounting folks were gone for the day):

Excerpt from Note 12 (modified):

... On November 17, 1997, the Company sold $350 million of 4% Convertible Subordinated Notes due November 15, 2002 (the "Notes"). The Notes are convertible into the Company's common stock at a conversion rate of 76,000 shares of common stock for each $1 million principal amount of the Notes... During fiscal 1999, 6.8 million shares of common stock were issued related to conversions... At June 30, 1999, the fair value of the Notes exceeded the book value by $2 billion as estimated by using quoted market prices... As of June 30, 1999, the book value of the Notes was $256 million,...

You also found that: (i) Interest on the notes is payable semiannually on June 30 and December 31. (ii) The notes were issued at a time when the effective interest rate was 4%

Required :

(a) What are the interest expense and interest payment for the 6-month period from July 1, 1999 to December 31, 1999 (for part (a), assume there are no conversions/repurchase of Notes in this period).

15 Question 8 (...continued)

(b) According to Note 12, during fiscal 1999, 6.8 million shares of common stock were issued related to conversion of notes. Which balance sheet accounts were affected by the conversion and by how much?

(c) Suppose that AOL repurchased the entire outstanding convertible notes on July 1, 1999 (i.e., the first day of fiscal 2000). Compute the effect of this transaction on the company’s fiscal 2000 income statement. Assume that AOL can purchase the notes at the closing market prices on June 30, 1999 and that the tax rate is 0%.

(d) Which balance sheet accounts would be affected by the repurchase of the notes and by how much?

16 Attachments for Questions 5-8: Selected portions of America Online’s 1999 financial statements.

AMERICA ONLINE INC Income Statement

Year ended (Amounts in millions, except per share data) June 30, 1999

Revenues: Subscription services $3,321 Advertising, commerce and other 1,000 Enterprise solutions 456 Total revenues 4,777

Costs and expenses: Cost of revenues 2,657 Sales and marketing 808 Product development 286 General and administrative 408 Amortization of goodwill and other intangible assets 65 Merger-related charges 95 Total costs and expenses 4,319

Income from operations 458 Other income, net 638 Income before provision for income taxes 1,096 Provision for income taxes (334) Net income $762

Earnings per share: Earnings per share-diluted $0.60 Earnings per share-basic $0.73 Weighted average shares outstanding-diluted 1,277 Weighted average shares outstanding-basic 1,041

17 AMERICA ONLINE INC Balance Sheet

(Amounts in millions, except per share data) June 30, 1999 June 30, 1998

ASSETS

Current assets: Cash and cash equivalents $887 $677 Short-term investments 537 146 Trade accounts receivable, less allowances of $54 323 192 and $34, respectively Other receivables 79 93 Prepaid expenses and other current assets 153 155 Total current assets 1,979 1,263

Long-term assets: Property and equipment at cost, net 657 503 Investments including available-for-sale securities 2,151 531 Product development costs, net 100 88 Goodwill and other intangible assets, net 454 472 Other assets 7 17 Total assets $5,348 $2,874

LIABILITIES AND STOCKHOLDERS' EQUITY

Current liabilities: Trade accounts payable $74 $120 Other accrued expenses and liabilities 795 461 Deferred revenue 646 420 Accrued personnel costs 134 78 Deferred network services credit 76 76 Total current liabilities 1,725 1,155

Long-term liabilities: Notes payable 348 372 Deferred revenue 30 71 Other liabilities 15 7 Deferred network services credit 197 273 Total liabilities 2,315 1,878

Stockholders' equity: Common stock, $.01 par value; 1,800,000,000 shares 11 10 authorized, 1,100,893,933 and 973,150,052 shares issued and outstanding at June 30, 1999 and 1998, respectively Additional paid-in capital 2,703 1,431 Unrealized gain on available-for-sale securities, net 168 145 Retained earnings (accumulated deficit) 151 (590) Total stockholders' equity 3,033 996 $5,348 $2,874