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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’ 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

Explain the difference between the proportional method and the incremental method of allocating the proceeds of lump-sum sales of capital stock.

On February 1, 2017, Buffalo Corporation issued 3,000 shares of its \(5 par value common stock for land worth \)31,000. Prepare the February 1, 2017, journal entry.

The books of Conchita Corporation carried the following account balances as of December 31, 2017.

Cash \( 195,000

Preferred Stock (6% cumulative, nonparticipating, \)50 par) 300,000

Common Stock (no-par value, 300,000 shares issued) 1,500,000

Paid-in Capital in Excess of Par—Preferred Stock 150,000

Treasury Stock (common 2,800 shares at cost) 33,600

Retained Earnings 105,000

The company decided not to pay any dividends in 2017.

The board of directors, at their annual meeting on December 21, 2018, declared the following: “The current year dividends shall be 6% on the preferred and \(.30 per share on the common. The dividends in arrears shall be paid by issuing 1,500 shares of treasury stock.” At the date of declaration, the preferred is selling at \)80 per share, and the common at \(12 per share. Net income for 2018 is estimated at \)77,000.

Instructions

a) Prepare the journal entries required for the dividend declaration and payment, assuming that they occur simultaneously.

b) Could Conchita Corporation give the preferred stockholders 2 years’ dividends and common stockholders a 30 cents per share dividend, all in cash?

Satchel Inc. purchases 10,000 shares of its own previously issued \(10 par common stock for \)290,000. Assuming the shares are held in the treasury with intent to reissue, what effect does this transaction have on (a) net income, (b) total assets, (c) total paid-in capital, and (d) total stockholders’ equity?

(Stock and Cash Dividends) Earnhart Corporation has outstanding 3,000,000 shares of common stock with a par value of \(10 each. The balance in its Retained Earnings account at January 1, 2017, was \)24,000,000, and it then had Paid-in Capital in Excess of Par—Common Stock of \(5,000,000. During 2017, the company’s net income was \)4,700,000. A cash dividend of \(0.60 a share was declared on May 5, 2017, and was paid June 30, 2017, and a 6% stock dividend was declared on November 30, 2017, and distributed to stockholders of record at the close of business on December 31, 2017. You have been asked to advise on the proper accounting treatment of the stock dividend.

The existing stock of the company is quoted on a national stock exchange. The market price of the stock has been as follows.

October 31, 2017 \)31

November 30, 2017 \(34

December 31, 2017 \)38

Instructions

  1. Prepare the journal entry to record the declaration and payment of the cash dividend.
  2. Prepare the journal entry to record the declaration and distribution of the stock dividend.
  3. Prepare the stockholders’ equity section (including schedules of retained earnings and additional paid-in capital) of the balance sheet of Earnhart Corporation for the year 2017 on the basis of the foregoing information. Draft a note to the financial statements setting forth the basis of the accounting for the stock dividend, and add separately appropriate comments or explanations regarding the basis chosen.
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