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CHAPTER 17

INTEGRATION OF FINANCIAL STATEMENT ANALYSIS TECHNIQUES

SOLUTIONS

1. A is correct. The capitalized value of Silk Road’s leases, the amount by which assets would increase, is estimated as the present value of the operating lease expense (payments). The present value of eight payments of 213 at 6.5 percent is 1,297.

2. B is correct. Adjusted EBIT = EBIT + Lease expense − Adjustment to depreciation = 318 + 213 − (1,297/8) = 369. Adjusted interest expense = Interest expense + Assumed interest expense on leases = 21 + (0.065 × 1, 297) = 105.3. Adjusted interest coverage ratio = 369/105.3 = 3.50.

3. C is correct. The capitalized value of the leases is added to assets and liabilities but does not impact equity. On an adjusted basis, Silk Road’s financial leverage ratio = (2,075 + 1,297)/1,156 = 2.92.

4. A is correct. Without the accounting change, Colorful Concepts has a financial leverage ratio = 3,844/2,562 = 1.50 and an interest coverage ratio = 865/35 = 24.71. These are both passing ratios. With the accounting change, the capitalized value of Colorful Concept’s leases is 2,472. The financial leverage ratio = (3,844 + 2,472)/2,562 = 2.46 and the interest coverage ratio = [865 + 406 − (2,472/8)]/[35 + (2,472 × 0.065)] = 4.91. These are both failing ratios. The change in interest rate coverage is particularly dramatic.