Exercise Chapter 6

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6/30/10 3:05 PM Page 503
Questions, Exercises, Problems, and Cases 503
and a subordinate certificate in the principal amount of $189 million (Subordinate

Certificate). The subsidiary retained the Subordinate Certificate, and the company
received $300 million in cash from the sale of the Senior Certificate to a third party.
The principal amount of the Subordinate Certificate fluctuates daily depending on the
volume of Receivables sold and is payable to the subsidiary only to the extent that
the collections received on the Receivables exceed amounts due on the Senior
Certificate. The full amount of the allowance for doubtful accounts related to the
Receivables sold has been retained, as the company has substantially the same credit
risk as if the Receivables had not been sold. Under the terms of the Facility, the
company is obligated to pay fees that approximate the purchaser’s cost of issuing a
like amount of commercial paper plus certain administrative costs.
Required
Delta requests your advice on the appropriate accounting for this transaction. How would
you respond?
c. In Year 2, a wholly owned subsidiary of Sun Company became a one-third partner
in Belvieu Environmental Fuels (BEF), a joint venture formed for the purpose of
constructing, owning, and operating a $220 million methyl tertiary butyl ether
(MTBE) production facility in Mont Belvieu, Texas. As of December 31, Year 3, BEF
had borrowed $128 million against a construction loan facility of which the com-
pany guarantees one-third, or $43 million. The plant, which has a designed daily
capacity of 12,600 barrels of MTBE, is expected to begin production in mid-Year 4.
When production commences, the construction loan will be converted into a five-
year, nonrecourse term loan with a first priority lien on all project assets.
To obtain a secure supply of oxygenates for the manufacture of reformulated fuels,
Sun has entered into a ten-year take-or-pay agreement with BEF, which commences
when the plant becomes operational. Pursuant to this agreement, Sun will purchase all
MTBE production from the plant. The minimum per-unit price to be paid for the
MTBE production while the nonrecourse term loan is outstanding will equal BEF’s
annual raw material and operating costs and debt service payments divided by the
plant’s annual designed capacity. Notwithstanding this minimum price, during the first
three years of the off-take agreement, Sun has agreed to pay BEF a price that approxi-
mates prices included in current MTBE long-term sales agreements in the marketplace.
This price is expected to exceed the minimum price required by the loan agreement.
Sun will negotiate a new pricing arrangement with BEF for the remaining years the
take-or-pay agreement is in effect. That pricing arrangement will be based on the
expected market conditions existing at the time.
Required
How should Sun account for this transaction?
6.20 EFFECT OF CAPITALIZING OPERATING LEASES ON BALANCE

SHEET RATIOS. Some retailing companies own their own stores or acquire their
premises under capital leases. Other retailing companies acquire the use of store facilities
under operating leases, contracting to make future payments. An analyst comparing the
capital structure risks of retailing companies may want to adjust reported financial state-
ment data to put all firms on a comparable basis.
Certain data from the financial statements of Gap Inc. and Limited Brands follow
(amounts in millions).
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504 Chapter 6 Financing Activities
Balance Sheet as of January 31, 2009 Gap Inc. Limited Brands

Current liabilities $2,158 $1,255
Long-term debt 0 2,897
Other noncurrent liabilities 1,019 946
Shareholders’ equity 4,387 1,874
Total $7,564 $6,972
Minimum Payments under Operating Leases

2009 $1,069 $ 478
2010 927 455
2011 712 416
2012 520 373
2013 386 341
After 2013 1,080 1,334
Total $4,694 $3,397
Required
a. Compute the present value of operating lease obligations using an 8 percent dis-
count rate for Gap Inc. and Limited Brands as of January 31, 2009. Assume that all
cash flows occur at the end of each year. Also assume that the minimum lease pay-
ment each year after 2013 equals $360 million per year for three years for Gap Inc.
and $333.5 million for four years for Limited Brands. (This payment scheduling
assumption can be obtained by assuming that the payment amount for 2013 contin-
ues until the aggregate payments after 2013 have been made, rounding the number
of years upward, and then assuming level payments for that number of years. For
Gap Inc.: $1,080/$386 2.8 years. Rounding up to three years creates a three-year
annuity of $1,080/3 years $360 million per year.)
b. Compute each of the following ratios for Gap, Inc. and Limited Brands as of January
31, 2009, using the amounts originally reported in their balance sheets for the year.
(1) Liabilities to Assets Ratio Total Liabilities/Total Assets
(2) Long-Term Debt to Long-Term Capital Ratio Long-Term Debt/(Long-Term
Debt + Shareholders’ Equity)
c. Repeat Part b but assume that these firms capitalize operating leases.
d. Comment on the results from Parts b and c.
6.21 STOCK-BASED COMPENSATION. Exhibit 6.16 includes a footnote
excerpt from the annual report of The Coca-Cola Company for Year 4. The beverage com-
pany offers stock options to key employees under plans approved by stockholders.
Required
Review Exhibit 6.16 and answer the following questions.
a. Coca-Cola reports both pretax and after-tax stock-based compensation in its notes
to the financial statements. What is the tax savings for Year 2, Year 3, and Year 4 that
Coca-Cola generates from the stock-based compensation provided to its employees?
Speculate on what income statement line item includes this tax savings as well as
what income statement line item includes the stock-based compensation expense.
(The income statement is not provided in this problem.)
b. The average option price per share and market price per share at time of grant is
equal each year ($44.69 for Year 2, $49.67 for Year 3, and $41.63 for Year 4). Discuss

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E-WAHLEN-09-1211-006.qxd:.

6/30/10 3:05 PM Page 503

Questions, Exercises, Problems, and Cases 503

and a subordinate certificate in the principal amount of $189 million (Subordinate

6.20 EFFECT OF CAPITALIZING OPERATING LEASES ON BALANCE

504 Chapter 6 Financing Activities

Balance Sheet as of January 31, 2009 Gap Inc. Limited Brands

Minimum Payments under Operating Leases

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