Consider a 7/1 ARM loan, starting at 5 percent with potential up-or-down yearly increments of 1 percent in the rate. Why is such an ARM loan potentially economically dangerous?

a. Actually, many people have financed their house with an ARM, and such loans are not considered potentially economically dangerous.

b. The loan interest rate can increase without limit over the life of the loan.

c. The loan interest rate for the example mentioned can start at 5 percent and increase to as much as 12 percent after 7 years, effectively doubling (+/-) the monthly payment.

d. The economic risk of an ARM loan is neutralized, because it is just as likely that the interest rate for the example mentioned could go down each year by the maximum amount.

Interstate Automobiles Corporation leased 40 vans to VIP Transport under a four-year noncancelable lease on January 1, 2018. Information concerning the lease and the vans follows:

a. Equal annual lease payments of $\$ 300,000$ are due on January 1, 2018, and thereafter on December 31 each year. The first payment was made January 1, 2018. Interstate's implicit interest rate is $10 \%$ and known by VIP. b. VIP has the option to purchase all of the vans at the end of the lease for a total of $\$ 290,000$. The vans' estimated residual value is $\$ 300,000$ at the end of the lease term and $\$ 50,000$ at the end of 7 years, the estimated life of each van. c. VIP estimates the fair value of the vans to be $\$ 1,240,000$. Interstate's cost was $\$ 1,050,000$. d. VIP's incremental borrowing rate is $9 \%$. e. VIP will pay the maintenance fees not included in the annual lease payments of $\$ 1,000$ per year. The depreciation method is straight-line. Your instructor will divide the class into two to six groups depending on the size of the class. The mission of your group is to assess the proper recording and reporting of the lease described.

Required:

1. Each group member should deliberate the situation independently and draft a tentative argument prior to the class session for which the case is assigned.
2. In class, each group will meet for 10 to 15 minutes in different areas of the classroom. During that meeting, group members will take turns sharing their suggestions for the purpose of arriving at a single group treatment.
3. After the allotted time, a spokesperson for each group (selected during the group meetings) will share the group's solution with the class. The goal of the class is to incorporate the views of each group into a consensus approach to the situation.

Specifically, you should address: a. Identify potential advantages to VIP of leasing the vans rather than purchasing them. b. How should the lease be classified by VIP? by Interstate? c. Regardless of your response to previous requirements, suppose VIP recorded the lease on January 1,2018 , as a finance lease in the amount of $\$ 1,100,000$. What would be the appropriate journal entries related to the finance lease for the second lease payment on December $31,2018 ?$

The Robinson Corporation has $\$ 43$ million of bonds outstanding that were issued at a coupon rate of $113 / 4$ percent seven years ago. Interest rates have fallen to $10^{3 / 4}$ percent. Mr. Brooks, the vice president of finance, does not expect rates to fall any further. The bonds have 17 years left to maturity, and Mr. Brooks would like to refund the bonds with a new issue of equal amount also having 17 years to maturity. The Robinson Corporation has a tax rate of 30 percent. The underwriting cost on the old issue was $2.4$ percent of the total bond value. The underwriting cost on the new issue will be $1.7$ percent of the total bond value. The original bond indenture contained a five-year protection against a call, with a 9 percent call premium starting in the sixth year and scheduled to decline by one-half percent each year thereafter. (Consider the bond to be seven years old for purposes of computing the premium.) Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole number. Calculate the present value of total outflows.

Ray now asks you to examine his company's credit policy to determine whether changes are needed. One of his employees, who graduated recently with a finance major, has recommended that the credit terms be changed from 2/10, net 30, to 3/20, net 45, and that both the credit standards and the collection policy be relaxed. According to the employee, such a change would cause sales to increase from $3.6 million to $4.0 million.

Currently, 62.5 percent of SSP's customers pay on Day 10 of the billing cycle and take the discount, 32 percent pay on Day 30, and 5.5 percent pay (on average) on Day 60. If the firm adopts the new credit policy, Ray thinks that 72.5 percent of customers would take the discount, 10 percent would pay on Day 45, and 17.5 percent would pay late, on Day 90. Bad debt losses for both policies are expected to be trivial.

SSP's variable operating costs are currently 75 percent of sales, its cost of funds is 10 percent, and its marginal tax rate is 40 percent. None of these factors would change as a result of a credit policy change. All cash payments associated with the production and sale of products (including credit costs) are made on the day the products are sold.

To help him decide whether to adopt the new policy, Ray has asked you to answer the question below.

What is the dollar amount of discounts granted under the current and the proposed credit policies?

The Sunbelt Corporation has $40 million of bonds outstanding that were issued at a coupon rate of$12^{7 / 8}$ percent seven years ago. Interest rates have fallen to 12 percent. Mr. Heath, the vice president of finance, does not expect rates to fall any further. The bonds have 18 years left to maturity, and Mr. Heath would like to refund the bonds with a new issue of equal amount also having 18 years to maturity. The Sunbelt Corporation has a tax rate of 36 percent. The underwriting cost on the old issue was 2.5 percent of the total bond value. The underwriting cost on the new issue will be 1.8 percent of the total bond value. The original bond indenture contained a five-year protection against a call, with an 8 percent call premium starting in the sixth year and scheduled to decline by one-half percent each year thereafter (consider the bond to be seven years old for purposes of computing the premium). Assume the discount rate is equal to the aftertax cost of new debt rounded up to the nearest whole number. Should the Sunbelt Corporation refund the old issue?

A person purchased a house 10 years ago for $160,000. The house was financed by paying 20% down and signing a 30-year mortgage at 7.75% on the unpaid balance. Equal monthly payments were made to amortize the loan over a 30-year period. The owner now (after the 120th payment) wishes to refinance the house due to a need for additional cash. If the loan company agrees to a new 30-year mortgage of 80% of the new appraised value of the house, which is$225,000, how much cash (to the nearest dollar) will the owner receive after repaying the balance of the original mortgage?

Go to finance.yahoo.com to find information about Vulcan Materials Company (VMC), Southwest Airlines (LUV), Honda Motor Company (HMC), Nordstrom, Inc. (JWN), and Abbott Laboratories (ABT). Download the most recent income statement and balance sheet for each company. a. Calculate the operating profit margin (operating profit/sales) and the asset turnover (sales/assets) for each firm. b. Calculate the return on assets directly (ROA = Operating profit/Total assets), and then confirm it by calculating ROA = Operating margin $\times$ Asset turnover. c. In what industries do these firms operate? Do the ratios make sense when you consider the industry types? d. For the firms that have relatively low ROAs, does the source of the problem seem to be the operating profit margin, the asset turnover, or both? e. Calculate the return on equity (ROE = Net income/Equity) for each firm. For the two firms with the lowest ROEs, perform a DuPont analysis to isolate the source(s) of the problem.

Dragonfly Limited (Dragonfly), a diversified electronics firm headquartered in Singapore, reported the following income statement information for its year ended December 31, Year 7. Dragonfly applies Singapore financial reporting standards and reports its results in thousands of Singapore dollars ($). In answering this problem, assume Dragonfly uses either U.S. GAAP or IFRS; for purposes of this problem, this choice will not matter.$

$$\begin{array}{lr} &{\text { Year } 7} \\ \hline \text{Sales}&\$ 460,830 \\ \text{Cost of Sales}&(416,378) \\ \hline\text{Gross Profit}& 44,452 \\ \text{Other Income }&1,558 \\ \text{Selling and Marketing Costs}&(20,714) \\ \text{General and Administrative Costs}&(20,254) \\ \text{Development Costs}&(1,232) \\ \text{Finance Costs, net}&(6,692) \\ \text{Gain on Sale of Land}&6,546 \\ \text{Share in Results of Associated Companies}&(2) \\ \hline \text{Profit Before Tax}&3,662 \\ \text{Taxation}&(1,094) \\ \hline \text{Profit (Loss)}& \$2,568 \\ \hline \hline \text{Portion of Profit Owned by Minority Interests}&(567) \\ \text{Portion of Profit Owned by Shareholders}&3,135 \\ \hline \end{array}$$

$Assume that Dragonfly supplied additional information about the following six hypothetical transactions or events that happened during Year 7, with all monetary amounts reported in thousands of Singapore dollars.

For each transaction, determine whether revenues and expenses for Year 7 are over- or understated.

e. In December Year 7, Dragonfly recognized interest income on investments in marketable securities of$230. The firm included this income in sales revenues.

The Holder Company's accounting are factored by Blair Finance. The following table lists all eight factored accounts along with the amount factored, the date due, and the status as of May 30. List the sums that Blair owed Holder as of May 30 along with the dates on which they were paid. Assume that the 2% commission paid to the factor is subtracted from the total amount of the remittance.

$$\begin{array}{crll} \text { Account } & \text { Amount } & \text { Date due } & \text { Status on May 30 } \\ \hline \text { A } & \$ 200,000 & \text { May 30 } & \text { Collected May 15 } \\ \text { B } & 90,000 & \text { May 30 } & \text { Uncollected } \\ \text { C } & 110,000 & \text { May 30 } & \text { Uncollected } \\ \text { D } & 85,000 & \text { June 15 } & \text { Collected May 30 } \\ \text { E } & 120,000 & \text { May 30 } & \text { Collected May 27 } \\ \text { F } & 180,000 & \text { June 15 } & \text { Collected May 30 } \\ \text { G } & 90,000 & \text { May 15 } & \text { Uncollected } \\ \text { H } & 30,000 & \text { June 30 } & \text { Collected May 30 } \end{array}$$

Ace Inc. produces electronic components for sale to manufacturers of radios, television sets, and digital sound systems. In connection with her examination of Ace’s financial statements for the year ended December 31, 2018, Gloria Rodd, CPA, completed field work 2 weeks ago. Ms. Rodd now is evaluating the significance of the following items prior to preparing her auditor’s report. Except as noted, none of these items have been disclosed in the financial statements or notes.

• Item 1: A 10-year loan agreement, which the company entered into 3 years ago, provides that dividend payments may not exceed net income earned after taxes subsequent to the date of the agreement. The balance of retained earnings at the date of the loan agreement was $420,000. From that date through December 31, 2018, net income after taxes has totaled$570,000 and cash dividends have totaled $320,000. On the basis of these data, the staff auditor assigned to this review concluded that there was no retained earnings restriction at December 31, 2018.
• Item 2: Recently Ace interrupted its policy of paying cash dividends quarterly to its stockholders. Dividends were paid regularly through 2017, discontinued for all of 2018 to finance purchase of equipment for the company’s new plant, and resumed in the first quarter of 2019. In the annual report, dividend policy is to be discussed in the president’s letter to stockholders.
• Item 3: A major electronics firm has introduced a line of products that will compete directly with Ace’s primary line, now being produced in the specially designed new plant. Because of manufacturing innovations, the competitor’s line will be of comparable quality but priced 50% below Ace’s line. The competitor announced its new line during the week following completion of field work. Ms. Rodd read the announcement in the newspaper and discussed the situation by telephone with Ace executives. Ace will meet the lower prices that are high enough to cover variable manufacturing and selling expenses but will permit recovery of only a portion of fixed costs.
• Item 4: The company’s new manufacturing plant building, which cost$2,400,000 and has an estimated life of 25 years, is leased from Wichita National Bank at an annual rental of $600,000. The company is obligated to pay property taxes, insurance, and maintenance. At the conclusion of its 10-year noncancelable lease, the company has the option of purchasing the property for$1. In Ace’s income statement, the rental payment is reported on a separate line.

For each of the above items, discuss any additional disclosures in the financial statements and notes that the auditor should recommend to her client. (The cumulative effect of the four items should not be considered.)

Gibraltar Industries is a Buffalo, New York–based manufacturer of high-value-added steel products. In a recent year, it reported the following activities:

$$\begin{array} {lrrrrr} \text{Acquisitions (investments in other companies)}& \hspace{10pt}\text{\$\hspace{10pt}(8,724)}&\\ \text{Decrease in inventories}& \hspace{10pt}\text{1,770}&\\ \text{Depreciation and amortization}& \text{33,907}&\\ \text{Long-term debt reduction}& \hspace{10pt}\text{(185,567)}&\\ \text{Net cash provided by operating activities}& \hspace{10pt}\text{107,874}&\\ \text{Net income}& \text{24,068}&\\ \text{Net proceeds from issuance of common stock}& \text{250}&\\ \text{Net proceeds from sale of property and equipment}& \hspace{10pt}\text{2,692}&\\ \text{Payment of dividends}& \hspace{10pt}\text{(5,985)}&\\ \text{Proceeds from long-term debt}& \text{53,439}&\\ \text{Proceeds from sale of other equity investments}& \text{34,701}&\\ \text{Purchases of property, plant, and equipment}& \text{(21,595)}&\\ \end{array}$$

Required:

1. Based on this information, present the cash flows from investing and financing activities sections of the cash flow statement.

2. Compute the capital acquisitions ratio. What does the ratio tell you about Gibraltar’s ability to finance purchases of property, plant, and equipment with cash provided by operating activities?

3. What do you think was Gibraltar management’s plan for the use of the cash generated by selling other equity investments?

In the book Cases in Finance, Nunnally and Plath present a case in which the estimated percentage of uncollectible accounts varies with the age of the account. Here the age of an unpaid account is the number of days elapsed since the invoice date.

An accountant believes that the percentage of accounts that will be uncollectible increases as the ages of the accounts increase. To test this theory, the accountant randomly selects independent samples of $500$ accounts with ages between $31$ and $60$ days and $500$ accounts with ages between $61$ and $90$ days from the accounts receivable ledger dated one year ago. When the sampled accounts are examined, it is found that $10$ of the $500$ accounts with ages between $31$ and $60$ days were eventually classified as uncollectible, while $27$ of the $500$ accounts with ages between $61$ and $90$ days were eventually classified as uncollectible. Let $p_1$ be the proportion of accounts with ages between $31$ and $60$ days that will be uncollectible, and let $p_2$ be the proportion of accounts with ages between $61$ and $90$ days that will be uncollectible.

Use the Minitab output below to determine how much evidence there is that we should reject $H_0: p_1-p_2=0$ in favor of $H_a: p_1-p_2 \neq 0$.

$$\begin{array}{lcccl} \text {Sample } & \mathrm{X} & \mathrm{N} & \text { Sample } \mathrm{p} & \\ 1 \text { (31 to } 60 \text { days) } & 10 & 500 & 0.020000 & \text { Difference }=\mathrm{p}(1)-\mathrm{p}(2) \\ 2 \text { (61 to 90 days } & 27 & 500 & 0.054000 & \text { Estimate for difference: }-0.034 \\ 95 \% \text { CI for difference: }(-0.0573036,-0.0106964) & \\ \text {Test for difference }=0 \text { (vs not }=0): \quad Z=-2.85 & \text { P-Value }=0.004 \end{array}$$

The unpaid balance of an installment loan is equal to the present value of the remaining payments. The unpaid balance, P, is given by $P=P M T \frac{\left[1-\left(1+\frac{r}{n}\right)^{-n t}\right]}{\left(\frac{r}{n}\right)}$, where PMT is the regular payment amount, r is the annual interest rate, n is the number of payments per year, and t is the number of years remaining in the loan. a. Use the loan payment formula to derive the unpaid balance formula. b. The price of a car is $24,000. You have saved 20% of the price as a down payment. After the down payment, the balance is financed with a 5-year loan at 9%. Determine the unpaid balance after three years. Round all calculations to the nearest dollar.

Buena Terra Corporation is reviewing its capital budget for the upcoming year. It has paid a $\$ 3.00$ dividend per share (DPS) for the past several years, and its shareholders expect the dividend to remain constant for the next several years. The company's target capital structure is $60 \%$ equity and $40 \%$ debt, it has $1,000,000$ shares of common equity outstanding, and its net income is $\$ 8$ million. The company forecasts that it will require $\$ 10$ million to fund all of its profitable (i.e., positive NPV) projects for the upcoming year.

a. If Buena Terra follows the residual dividend model, how much retained earnings will it need to fund its capital budget?

b. If Buena Terra follows the residual dividend model, what will be the company's dividend per share and payout ratio for the upcoming year?

c. If Buena Terra maintains its current $\$ 3.00$ DPS for next year, how much retained earnings will be available for the firm's capital budget?

d. Can the company maintain its current capital structure, the $\$ 3.00$ DPS, and a $\$ 10$ million capital budget without having to raise new common stock?

e. Suppose that Buena Terra's management is firmly opposed to cutting the dividend; that is, it wants to maintain the $\$ 3.00$ dividend for the next year. Also, assume that the company was committed to funding all profitable projects and was willing to issue more debt (along with the available retained earnings) to help finance the company's capital budget. Assume that the resulting change in capital structure has a minimal effect on the company's composite cost of capital so that the capital budget remains at $\$ 10$ million. What portion of this year's capital budget would have to be financed with debt?

f. Suppose once again that Buena Terra's management wants to maintain the $\$ 3.00$ DPS. In addition, the company wants to maintain its target capital structure ( $60 \%$ equity and $40 \%$ debt) and its $\$ 10$ million capital budget. What is the minimum dollar amount of new common stock that the company would have to issue to meet each of its objectives?

g. Now consider the case where Buena Terra's management wants to maintain the $\$ 3.00$ DPS and its target capital structure, but it wants to avoid issuing new common stock. The company is willing to cut its capital budget to meet its other objectives. Assuming that the company's projects are divisible, what will be the company's capital budget for the next year?

h. What actions can a firm that follows the residual dividend model take when its forecasted retained earnings are less than the retained earnings required to fund its capital budget?