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Chapter 15: Q20E. (page 817)

(Trading on the Equity Analysis) Presented below is information from the annual report of Emporia Plastics, Inc.

Operating income

\( 532,150

Bond interest expense

135,000

397,150

Income taxes

183,432

Net income

\) 213,718

Bonds payable

$1,000,000

Common stock

875,000

Retained earnings

375,000

Instructions

  1. Compute the return on common stockholders鈥� equity and the rate of interest paid on bonds. (Assume balances for debt and equity accounts approximate averages for the year.)
  2. Is Emporia Plastics, Inc. trading on the equity successfully? Explain.

Short Answer

Expert verified

The rate of return on common stock equity is 17.1%,and the rate of interest on bonds payable is13.5%.

Step by step solution

01

Meaning of Equity

Equity represents the value derived by the owners. Based on the company's balance sheet, the value of equity is determined as the difference between assets and liabilities. Themarket value of equity is determined by either the existing share price (if publicly traded) or by the valuation of a professional.

02

Computing the return on common stockholders’ equity and the rates of interest paid on bonds.

ReturnonCommonStockEquity=NetIncomeCommonstock+RetainedEarnings=$213,718$1,250,000=17.1%

ReturnonBondspayable=BondsInterestExpenseBondsPayable=$135,000$1,000,000=13.5%

03

Explaining the trading on the equity of Emporia Plastics, Inc.

Emporia Plastics, Inc. is trading on the equity successfully since its return on common stock equity is greater than the interest paid on bonds.

Note: Some analysts use after-tax interest expense to compute the bond rate.

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Most popular questions from this chapter

Faith Evans Corporation is a regional company which is an SEC registrant. The corporation鈥檚 securities are thinly traded on NASDAQ. Faith Evans Corp. has issued 10,000 units. Each unit consists of a \(500 par, 12% subordinated debenture and 10 shares of \)5 par common stock. The units were sold to outside investors for cash at \(880 per unit. Prior to this sale, the 2-week ask price of common stock was \)40 per share. Twelve percent is a reasonable market yield for the debentures, and therefore the par value of the bonds is equal to the fair value.

Instructions

  1. Prepare the journal entry to record Evans鈥� transaction, under the following conditions.
  2. Employing the incremental method.
  3. Employing the proportional method, assuming the recent price quote on the common stock reflects fair value.
  4. Briefly explain which method is, in your opinion, the better method.

In the absence of restrictive provisions, what are the basic rights of stockholders of a corporation?

(Computation of Retained Earnings) The following information has been taken from the ledger accounts of Isaac Stern Corporation.

Total income since incorporation $317,000

Cash dividends paid 60,000

Total value of stock dividends distributed 30,000

Gains on treasury stock transactions 18,000

Unamortized discount on bonds payable 32,000

Instructions

Determine the current balance of retained earnings.

(Computation of Book Value per Share) Morgan Sondgeroth Inc. began operations in January 2015 and reported the following results for each of its 3 years of operations.

2015 \(260,000net loss 2016 \)40,000 net loss 2017 \(800,000 net income

At December 31, 2017, Morgan Sondgeroth Inc. capital accounts were as follows.

8% cumulative preferred stock, par value \)100;

authorized, issued, and outstanding 5,000 shares \(500,000

Common stock, par value \)1.00; authorized 1,000,000 shares;

issued and outstanding 750,000 shares \(750,000

Morgan Sondgeroth Inc. has never paid a cash or stock dividend. There has been no change in the capital accounts since Sondgeroth began operations. The state law permits dividends only from retained earnings.

Instructions

  1. Compute the book value of the common stock on December 31, 2017.
  2. Compute the book value of the common stock on December 31, 2017, assuming that the preferred stock has a liquidating value of \)106 per share.

(Equity Transactions and Statement Preparation) On January 5, 2017, Phelps Corporation received a charter granting the right to issue 5,000 shares of \(100 par value, 8% cumulative and nonparticipating preferred stock, and 50,000 shares of \)10 par value common stock. It then completed these transactions.

Jan. 11 Issued 20,000 shares of common stock at \(16 per share.

Feb. 1 Issued to Sanchez Corp. 4,000 shares of preferred stock for the

following assets: equipment with a fair value of \)50,000; a factory

building with a fair value of \(160,000; and land with an

appraised value of \)270,000.

July 29 Purchased 1,800 shares of common stock at \(17 per share. (Use cost

method.)

Aug. 10 Sold the 1,800 treasury shares at \)14 per share.

Dec. 31 Declared a \(0.25 per share cash dividend on the common stock and

declared the preferred dividend.

Dec. 31 Closed the Income Summary account. There was a \)175,700 net

income.

Instructions

  1. Record the journal entries for the transactions listed above.
  2. Prepare the stockholders鈥� equity section of Phelps Corporation鈥檚 balance sheet as of December 31, 2017.
See all solutions

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