Name Instructions This exam is 100 minutes long. Upon receiving the exam, you should write down your name and the section you attend the class. Then read the remainder of this page and stop. Do not proceed beyond this cover page till you are told to do so by the proctor. 1. This exam has 3 questions and 9 pages. Check your copy of the exam to make sure you have a complete copy. 2. Use your time well: do the easy parts first. 3. Show all your work and write down your assumptions wherever possible. It may help you earn partial or substantial credit. 4. Make sure you read all pages of the exam and follow instructions exactly. If answers are illegible, incomprehensible or written down in the wrong place, we may fail to evaluate them correctly. 5. The exam is closed book, no-notes. Only numeric calculators should be used. Textstoring calculators may be used only if you have purged all stored text. Students are presumed to be familiar with the Code of Policies and Regulations Applying to All Students. In particular, please the following provision (ibid, 33): It is the responsibility of the student to refrain from infractions of academic integrity, from conduct that may lead to suspicion of such infractions, and from conduct that aids others in such infractions. Detected violations of academic integrity will result in a score of zero for this exam as well as additional disciplinary action consistent with University policy. 6. No questions will be answered during the exam. If you cannot understand some part of the exam, if you find a typographical error or if you believe the exam is in any way erroneous or unworkable, please state your difficulty in writing on the exam itself. 7. This exam is a test of your individual knowledge and ability to complete the assigned tasks at this moment in time. You may not consult anybody regarding any portions of the exam before you turn it in to the proctor. 8. If you need to leave the room during the exam for personal reasons, you may do so after seeking the permission of the proctor. Before leaving your seat, please make sure that your exam is closed and turned over so that no writing is visible. You should turn off or put away your calculators as well. 1/10
Question 1 (20 points) This question has two parts. On March 1, 2004, Orange Company issued 800 $1,000 bonds at 104. Each bond was issued with one detachable stock warrant. At the date of issuance, the bonds, without the stock warrants, were selling at 96. The market value of each detachable warrant was quoted at $40. Required (show computations for credits): a) Prepare the entry to record the issuance of the bonds and warrants. Market value of bonds without warrants $768,000 ($800*1,000 *.96) Market value of warrants 32,000 (800 X $40) Total market value $800,000 $768,000X $832,000 = $798,720 Value assigned to bonds $800,000 $ 32,000 X $832,000 = $33,280 Value assigned to warrants $800,000 Cash 832,000 Discount on Bonds Payable 1,280 Bonds Payable. 800,000 Paid-in Capital Stock Warrants 33,280 b) Assume the same facts as Part (a), except that the market value of the warrants cannot be determined. Prepare the entry to record the issuance of the bonds and warrants. Cash (800*1,000*1.04) 832,,000 Discount on Bonds Payable 32,000* Bonds Payable 800,000 Paid-in Capital Stock Warrants 64,000 ** * [(1.96) X $1,000*800] ** $832,000 ($800,000 X.96) 2/10
Question 2 (30 points) This question has two parts. Part a is presented on this page, part b on the next. Birney Corp. had $900,000 net income in 2004. On January 1, 2004 there were 220,000 shares of common stock outstanding. On April 1, 20,000 shares were issued and on September 1, Birney bought 30,000 shares of treasury stock. There are 30,000 options to buy common stock at $40 a share outstanding. The market price of the common stock averaged $50 during 2004. The tax rate is 40%. During 2004, there were 20,000 shares of convertible preferred stock outstanding. The preferred is $100 par, pays $7 a year dividend, and is convertible into 3 shares of common stock. Birney issued $2,000,000 of 8% convertible bonds at face value during 2003. Each $1,000 bond is convertible into 20 shares of common stock. Required (show computations for credit): a) Compute and present in good form basic earnings per share for 2004 (rounded to the nearest penny). NI $900,000 Less: PS dividend requirement (140,000) Income applicable to Common $760,000 Weighted average CS outstanding 225,000* Basic EPS ($760,000/225,000) $3.38 *1/1/04 Beginning balance 220,000*3/12= 55,000 4/1/04 Issued 20,000 shares 240,000*5/12= 100,000 9/1/04 Purchased 30,000 treasury shares 210,000*4/12= 70,000 Weighted average number of shares outstanding 225,000 3/10
Question 2 (continued) b) Compute and present in good form diluted earnings per share for 2004 (rounded to the nearest penny). Step 1: Stand-alone effects 1) Preferred stock dividend 20,000*7= $140,000 Income tax effect none Dividend requirement avoided $140,000 Number of CS issued assuming conversion of PS 20,000*3= 60,000 shares Per share effect: Incremental numerator effect $140,000 = = $2.33 Incremental denominator effect 60,000 2) Interest expense for year (8% * 2,000,000) $160,000 Income tax deduction due to interest (40%*160,000) (64,000) Interest expense avoided (Net of tax) $ 96,000 Number of CS issued assuming conversion of bonds 2,000,000/1000*20=40,000 Per share effect: Incremental numerator effect $96,000 = = $2.4 Incremental denominator effect 40,000 3) Number of shares under option 30,000 Option price per share x $40 Proceeds upon assumed exercise of options $120,000 Average 2004 market price of common $50 Treasury shares that could be acquired with proceeds (1200,000/50) 24,000 Excess of shares under option over treasury shares that could be repurchased (30,000-24,000) 6,000 Per share effect: Incremental numerator effect $0 = = $ 0 Incremental denominator effect 6,000 4/10
Step 2: Ranking of per share effect: 1. Options $0 2. Convertible PS $2.33 3. 8% convertible bonds $2.4 Step 3: Fully Diluted EPS Computations 1) Options NI applicable to CS shareholders $760,000 Add: incremental numerator effect of options None Total $760,000 Weighted average number of CS outstanding 225,000 shares Add: incremental denominator effect of options 6,000 shares Total 231,000 shares Recomputed EPS (760,000/231,000) $3.29 Conversion of options causes diluted EPS to fall from $3.38 to $3.29. 2) Convertible PS NI applicable to CS shareholders $760,000 Add: dividend requirement avoided 140,000 Total $900,000 Weighted average number of CS outstanding 231,000 shares Add: number of CS assumed issued upon conversion of PS 60,000 shares Total 291,000 Recomputed EPS (900,000/291,000) $3.09 Conversion of PS further dilutes EPS from $3.29 to $3.09. 3) 8% convertible bond Numerator from previous calculation $900,000 Add: interest expense avoided (Net of tax) 96,000 Total 996,000 Denominator from previous calculation 291,000 Add: number of CS assumed issued upon conversion of bonds 40,000 Total 331,000 Recomputed EPS (996,000/331,000) $3.01 Bond conversion further reduces EPS from $3.09 to $3.01. This is fully diluted EPS. 5/10
Question 3 (30 points) Shareholders equity for Blue Company on 1/1/2004, was: Preferred stock--$50 par, 6% cumulative (100,000 shares outstanding) $5,000,000 Common stock--$2 par (1,000,000 shares outstanding) 2,000,000 Paid-in capital 10,000,000 Retained earnings 53,000,000 $70,000,000 The following equity events occurred throughout 2004: 1. On March 1, 30,000 shares of common stock were acquired as treasury stock for $20 per share. 2. On June 30, the board of directors declared a dividend for both the preferred shareholders preference and $2 per share for common shareholders; the dividend was distributed on August 15 to shareholders of record on July 31. There were no dividends in arrears. 3. On September 30, the company reissued 10,000 shares of treasury stock for $18 per share. 4. On December 30, the company declared a 10% common stock dividend to be distributed on January 31, 2005, to shareholders of record on January 15, 2005. The market price per share was $21 on 12/30/2004, $22 on 1/15/2005, and $23 on 1/31/2005. 5. Net income for 2004 was $11,000,000. Required (show computations for credit): Using the cost method for treasury stock, prepare journal entries for each transaction. 6/10
Question 3 (continued) 3/1/04 Treasury Stock $600,000 Cash $600,000 6/30/04 Retained earnings (cash dividend declared) $2,240,000 PS dividend payable $300,000 CS dividend payable $1,940,000* * (1000,000-30,000)x$2=$1,940,000 7/31/04 no entry 8/15/04 PS dividend payable $300,000 CS dividend payable $1,940,000 Cash $2,240,000 9/30/04 Cash $180,000 PIC-TS $20,000 TS $200,000 12/30/04 Retained earnings (stock dividend declared) $2,058,000 CS dividend distributable $196,000 PIC-CS $1,862,000 1/15/05 no entry 1/31/05 CS dividend distributable $196,000 CS $196,000 7/10
Question 4 (20 points) Reproduced below is are excerpts from a recent Wall Street Journal story on the dismissal of Hewlett Packard Company s CEO. Hewlett-Packard Co.'s board, amid mounting displeasure with the Silicon Valley computer giant's performance, ousted Chief Executive Carly Fiorina after she resisted the directors' plan for her to cede some day-to-day authority to the heads of H-P's key business units. The move culminated weeks of escalating pressure from the board on Ms. Fiorina, one of the most powerful women in business. She bet her career that a bitterly contested $19 billion merger with Compaq Computer Corp. would give H-P enough scale to thrive in the brutally competitive market for computer hardware. But with H-P's stock down more than 50% since the start of Ms. Fiorina's tenure as CEO, H-P's board decided on the managementreorganization plan at a mid-january meeting. The decision came after three directors presented a four-page analysis laying out the board's concerns about the company's performance after 5½ years with Ms. Fiorina as CEO. People familiar with the matter said directors felt too much of the company's vast operations had been centralized in Ms. Fiorina's office, creating decision-making bottlenecks. Meanwhile, H-P had failed to meet key performance targets Ms. Fiorina had set for the company during the Compaq takeover fight. Board members stressed yesterday that the ouster didn't imply that the company would change its strategy. But the dramatic move has renewed speculation that the company might revisit the question of spinning off its highly profitable printing and imaging business. The unit supplies roughly 75% of the company's profits, largely from the mundane business of selling ink cartridges. <snip> The abrupt turn of events signals a new chapter for a storied Silicon Valley icon. H-P was famously founded in the garage of David Packard's house in 1939. He and co-founder William Hewlett known throughout the company as Bill and Dave took a firm that made oscillators and built it into a giant selling scientific instruments and computers. Today it is a printing, PC and computer-services giant, employing 150,000 people and bringing in annual revenue of $80 billion. Unlike H-P's earlier home-grown, technology-focused CEOs, Ms. Fiorina, the former head of Lucent Technologies Inc., came from a sales background. She had a flair for marketing and public speaking, and jetted world-wide to visit customers, employees, shareholders and world leaders. She greatly expanded H-P's fleet of corporate jets and attracted criticism for everything from her hairstyle to her designer suits. <snip> Robert Wayman, H-P's longtime chief financial officer, was appointed interim CEO and was re-appointed to the Palo Alto, Calif., company's board. Mr. Wayman had served on the board from 1993 to 2002. Ms. Dunn, the new chairman, said H-P is hiring a search firm to find a new CEO, with the entire nine-member board acting as a search committee. While both internal and external candidates will be considered, Ms. Dunn said she "anticipates an external candidate" will ultimately be selected, "but we don't know for sure." Mr. Wayman, the interim CEO, will continue to serve as finance chief during this transition period. He has been discussing retiring for the past few years. Mr. Wayman said that H-P's fiscal firstquarter results expected next Wednesday would be in line with Wall Street expectations. Ms. Fiorina's ouster reflects increasingly clear strategic problems at H-P. The company faces fierce competition from Dell Inc. in personal computers and International Business Machines Corp. in computer services and corporate computing. In a recent interview with Fortune Magazine, Mr. Wayman conceded that the centerpiece of Ms. Fiorina's strategy -- the 2002 acquisition of Compaq -- might require a write-down. "There's no question that if profitability doesn't improve, there will be an impairment charge," he said. <snip> 8/10
Question 4 (continued) WSJ excerpts continued Investors cheered the news of Ms. Fiorina's departure. In 4 p.m. composite trading on the New York Stock Exchange, H-P's shares rose 6.9%, or $1.39, to $21.53. H-P's revenue soared during her tenure, in part because of the acquisition of Compaq. Since 1999, revenue has roughly doubled, while net income for 2004, after dropping in her early years as the tech bubble burst, has returned to its 1999 levels. In November, the company reported fiscal 2004 net income of $3.5 billion, up 38% from a year earlier, while revenue at $80 billion was up 9%. One central concern: H-P had failed to achieve the profitability targets from the Compaq deal. As part of the proxy fight, H-P committed to corporate operating-profit margins of 8% to 10%, and margins of 3% in its PC division. In the fiscal year ended Oct. 31, H-P posted operating-profit margins of 6.3%, and the PC group reported margins of 1%. Key parts of HP s balance sheets for the last 5 years are reproduced below. 10/31/2004 10/31/2003 10/31/2002 10/31/2001 10/31/2000 Restated 10/31/2004 Reclassified 0/31/2003 Total Current Assets 42,901 40,954 36,075 21,305 23,244 Land 657 810 772 323 346 Buildings/Impr. 5,752 4,959 4,787 3,732 3,644 Machinery/Equip. 7,427 7,530 6,977 5,753 5,515 Depreciation -7,187-6,817-5,612-5,411-5,005 LT Invest./Other 6,657 8,030 7,758 6,126 6,265 Goodwill/Other 15,828 14,894 15,089 667 Purch. Intang. 4,103 4,356 4,864 89 Total Assets 76,138 74,716 70,710 32,584 34,009 Required: With the utmost brevity you can muster, 1. (8 points) List up to four likely repercussions of these events on HP s 2005 financial statements. [Hint: Think first of the alternative courses of action open to HP management and of the operational consequences of those choices. How will those choices affect the numbers reported/reportable in the 2005 financial statements?] 2. (12 points) For each of the four potential financial statement effects you identify, describe as clearly as you can (a) the statement(s) likely to be affected, (b) the relevant section of the financial statements where you think the impact will show up (e.g. Income from Continuing Operations or Net Income or Other Comprehensive Income, Cash Flows from Operations or Cash Flows from Investing Activities or Cash Flow from Financing Activities, etc.) and (c) to the extent possible, the magnitude (dollar impact) of the effect. [Hint: Sketch out the journal entries wherever you can, even if you can t put dollars on it.] 3. For extra credit (5 points) identify the relevant financial reporting standards that address the recognition and measurement of these effects. 9/10
Question 4 (continued) Part 1. Some obvious impacts: 1. Goodwill impairment 2. Asset Impairment (PPE, Other Assets e.g. Acquired R&D) 3. Employee termination costs 4. Contract termination costs & other exit costs Some not-so-obvious ones: 1. Reduction in fixed costs (move away from corporate jets, real vs. symbolic steps) 2. Costs associated with new acquisitions (costs of refocusing, acquiring targets) 3. Increase in sales/output as a result of employee morale and motivation improvement 4. Decreases in sales/output as succession battles and transition continue to distract In general, there should be a negative impact on NI and correspondingly a reduction in both assets and stockholders equity. The exact timing of the impact on net income and cash flows will, in general not be the same. Moreover the timing of expense recognition and asset write-offs as well as the magnitudes involved will depend on the item in question, see FAS 142/144/146 for guidance (citing these standards anywhere in the answer satisfies the requirements for extra credit). Many of these effects are much hard to estimate and in the decidedly speculative category (as the eminent market guru Y. Berra says, "It's hard to make predictions, especially about the future"). However the actual #s will no doubt be closely parsed for information HP s future cash flows. Part 2 (Any reasonable answers are acceptable.) Income statement effects: Estimated future expenses and provisions as well as any asset impairment charges usually show up in income from continuing operations (e.g. FAS 142, par 43; FAS 144, par 25) unless they relate to discontinued operations in which case, FAS 144 says the use of the old APB 30 format of separating out income from discontinued operations can be continued. Dollar amounts can be guessed by assuming goodwill and purchased intangibles may have to be substantially impaired. Cash flow statement effect and implications can be though through using the idea that CFO (cash from operations) = NI + Depr & Amort + Other Non-Cash Charges. Balance Sheet effects are basically the other side of the journal entries you would make for the income statement effects so I leave you to imagine these. Part 3 See standards identified in answer to part 1. Other relevant standards are acceptable as well. 10/10