Answer the questions as required

Credit Analysis and Financial DistressAcct 503B Fall 2023
Week 6
1
Credit Analysis and Financial Distress –
Agenda
How does valuation of bonds differ from the valuation of stock?
– Payoffs as a function of firm value
– Stock is a call option given by bondholders to stockholders
Bond ratings
Bondholders will focus on measures of default probability. These
include measures of
– Liquidity (short-term cash availability)
– Solvency (long-term cash availability)
– Size and profitability
– The variance of the firm’s common stock
Bankruptcy prediction
Acct 503B Fall 2023
Week 6
2
Corporate Debt v Equity
Quick comparison
1. More debt is issued each year than equity
– 2022=YTD Debt = $1,142B; Equity = $77.2B
2. Equity is more liquid than debt
– 2022 Ave. Daily Volume Debt = $39B; Equity = $604B
3. Equity market is larger in value than corporate debt market
– 2022 2Q Outstanding Debt = $10.1T; 3Q Equity = $37.9T
4. 91.3% of Corporate debt issues 2022YTD are low default risk
(“investment grade)
Points 2, 3, and 4 suggest that far more resources are devoted to
analyzing corporate equity. Commercial loans by banks = $2.4T.
Evaluating these loans requires substantial credit analysis.
3
Acct 503B Fall 2023
(Source: SIFMA andWeek
FRED,
2022)
6
Valuation of Stock vs Valuation of Bonds
Payoffs as a function of Asset Value
To understand why valuation of bonds differs from valuation of
stocks we must first understand how the payoffs of these securities
differ as a function of firm value (V).
Assume:
V = value of the firm’s assets
P = promised payment on debt (including interest)
Stockholders’ payoff = maximum (0, V-P)
Bondholders’ payoff = minimum (V, P)
Bondholders lack the “upside” potential of stockholders.
– Cash flows promised by the firm to bondholders are
“capped.”
– After payment of principal and interest are assured,
bondholders receive no benefit from additional profits
generated by the firm.
Acct 503B Fall 2023
Week 6
4
Valuation of Stock vs Valuation of Bonds
Payoffs as a function of Asset Value
$
Payoff to Bondholders
P
Payoff to Stockholders
0
Value of Assets (V)
P (amounted owed on debt)
Acct 503B Fall 2023
Week 6
5
Valuation of Stock vs Valuation of Bonds
Payoffs as a function of Asset Value
$

Payoff to Stockholders
P
0
Once the value of firm’s assets is in
this region, stockholders’ value
(i.e., their expected payoffs)
changes very little.

Stockholders focus their
analysis on figuring out
where the firm will be
in this region.
Value of Assets (V)
P (amounted owed on debt)
Acct 503B Fall 2023
Week 6
6
Valuation of Stock vs Valuation of Bonds
Payoffs as a function of Asset Value
$
Bondholders focus their
analysis on figuring out
where the firm will be
in this region.
Payoff to Bondholders
P
Once the value of firm’s assets is in
this region, bondholders’ value
(i.e., their expected payoffs)
changes very little.
0
V
P
Acct 503B Fall 2023
Week 6
7
Valuation of Stock vs Valuation of Bonds
Differences between stock and bond valuation
Unlike stockholders, bondholders will focus their analysis on
situations where the value of the firm’s assets is less then P.
– Bondholders try to predict what would happen in default
• What is the liquidation value of the assets?
– Are the assets fungible or are they valuable only to this
company? How easy is it to covert them into cash?
– Banks will loan more readily on Accounts Receivable than on
PP&E.
– Evidence: Benmelech (2005) found railroads with more
common track gauge had longer debt maturities
• Do other creditors have senior claims in bankruptcy?
Acct 503B Fall 2023
Week 6
8
Valuation of Stock vs Valuation of Bonds
Differences between stock and bond valuation
Unlike stockholders, bondholders will place little weight on
growth or cash inflows that will only occur if the firm continues
to operate i.e., when V > P.
– Bondholders do not participate in these payouts so the
existence of this growth is irrelevant to bondholders.
– Examples include
(1) growth options, i.e., the option to expand if the firm’s current
investments are successful
(2) growth beyond a given threshold
– Bondholders care about growth only to the extent that it
provides an indication of the health of the firm’s current
operations
Acct 503B Fall 2023
Week 6
9
Valuation of Stock vs Valuation of Bonds
Bondholders have given stockholders a call option
The exercise price of the option is the promised payment on the
debt (P).
Stockholders will exercise the option (i.e., retain control of the
firm) if the value of the firm’s assets (V) exceeds the promised
payment on the debt (P).
Implications of thinking about stock as a call option
– Wealth is transferred from bondholders to stockholders
when the variance of the value of the firm’s assets
increases
– This option can create an “underinvestment problem.”
That is, shareholders will not want to invest in profitable
projects, because a portion of the payout from these
projects goes to the bondholders.
Acct 503B Fall 2023
Week 6
10
Valuation of Stock vs Valuation of Bonds
Bondholders have given stockholders a call option
Wealth is transferred from bondholders to stockholders when the
variance of the value of the firm’s assets increases.
Assume (1) bondholders are owed $25, (2) initially, firm assets are
expected to be worth either $15 or $25 when debt comes due, (3)
shareholders take actions that change these values to $35 or $5.
Initial possible values
of firm assets
(1)
Possible values after
shareholder actions
$25
$35
$15
$5
(1A)
Acct 503B Fall 2023
Week 6
11
Valuation of Stock vs Valuation of Bonds
Bondholders have given stockholders a call option
Wealth is transferred from bondholders to stockholders when the
variance of the value of the firm’s assets increases
(1)
Expected value of bond = .5 × $25 + .5 × $15 = $20
Expected value of stock = .5 × $0 + .5 × $0 = $0
By increasing the variance of the payout, the owners have
transferred $5 from the bondholders to themselves.
(1A)
Expected value of bond = .5 × $25 + .5 × $5 = $15
Expected value of stock = .5 × $0 + .5 × ($35 – $25) = $5
Acct 503B Fall 2023
Week 6
12
Valuation of Stock vs Valuation of Bonds
Bondholders have given stockholders a call option
The possibility of default creates an underinvestment problem.
Assume (1) bondholders are owed $25, (2) initially, firms assets are
expected to be worth either $15 or $25 when debt comes due, (3)
shareholders can invest $2 and increase these values to $18 and $28.
A 50% return on investment! Will shareholders make the
investment?
Initial possible values
of firm assets
(1)
Possible values after
shareholder investment
$25
$28
$15
$18
(1B)
Acct 503B Fall 2023
Week 6
13
Valuation of Stock vs Valuation of Bonds
Bondholders have given stockholders a call option
The possibility of default creates an underinvestment problem.
As the firm approaches default, shareholders become less willing to
invest because they must share the returns with bondholders.
(1)
Expected value of bond = .5 × $25 + .5 × $15 = $20
Expected value of stock = .5 × $0 + .5 × $0 = $0
Shareholders will not make the $2 investment, because it
only increases their payoff by $1.50.
(1B)
Expected value of bond = .5 × $25 + .5 × $18 = $21.50
Expected value of stock = .5 × $0 + .5 × ($28 – $25) = $1.50
Acct 503B Fall 2023
Week 6
14
Valuation of Stock vs Valuation of Bonds
Bondholders have given stockholders a call option
Three conflicts between bondholders and stockholders
intensify as bankruptcy approaches
– Asset substitution
• Increases in variance of firm’s assets
– Underinvestment
• Shareholders become unwilling to invest in projects
even though these projects increase the value of the
firm.
– Liquidating the firm
• Paying out a large dividend to shareholders
Acct 503B Fall 2023
Week 6
15
Valuation of Stock vs Valuation of Bonds
Similarities between stock and bond valuation
The value of corporate bonds, like the value of common stock
depends on the future profitability of the firm.
– Lenders do not want to loan money to an unprofitable firm or a
firm with a poor competitive strategy.
The value of common stock, like the value of corporate bonds is
reduced in bankruptcy.
– Therefore, stockholders like bondholders are concerned about
the liquidity and solvency of the firm.
Lenders, like stockholders, should evaluate the company’s strategy,
profitability, and accounting quality.
Acct 503B Fall 2023
Week 6
16
Credit Analysis and Financial Distress
Bond Ratings
Standard and Poor’s and Moody’s and others rate bonds
These ratings provide investors with a measure of default risk
Ratings changes, particularly downgrades seem to convey
information to the market
– Stock price drops 3.96% on the date of down grade announcement
– Stock price increases 0.47% on the date of an up grade announcement, not
statistically significant
– The reaction has increased since the implementation of Regulation FD which
prevents private conversations between analysts and management, because
rating agencies are exempt from FD.
Acct 503B Fall 2023
Week 6
17
Bond Ratings
Proceeds of debt issues by rating category
Acct 503B Fall 2023
Week 6
18
Measures of Default Probability
Distribution of Bond Ratings on Capital IQ
Acct 503B Fall 2023
Week 6
19
Bond Ratings
Yield of Bond Issue minus Yield of Treasury Bond
Acct 503B Fall 2023
Week 6
20
Measures of Default Probability
Liquidity
Availability of company resources to meet short-term cash
requirements. Relates to the timing of cash inflows and outflows
– Working capital and current ratios
• Current ratio
Current assets / current liabilities
• Quick ratio
Cash + short-term investments + accts. rec./ current liabilities
• Cash ratio
Cash + marketable securities / current liabilities
• Operating-cash-flow ratio
Cash flow from operations / current liabilities
– Receivables and inventory turnover
• Sales / AR and Cost of goods sold / inventory
• Provides information on the quality of specific current assets
Acct 503B Fall 2023
Week 6
21
Measures of Default Probability
Liquidity
Acct 503B Fall 2023
Week 6
22
Measures of Default Probability
Liquidity
Acct 503B Fall 2023
Week 6
23
Measures of Default Probability
Liquidity
Acct 503B Fall 2023
Week 6
24
Measures of Default Probability
Liquidity
Acct 503B Fall 2023
Week 6
25
Measures of Default Probability
Liquidity
What do these graphs tell us?
– Correlation between default risk and current ratios is
low. Why?
Acct 503B Fall 2023
Week 6
26
Measures of Default Probability
Liquidity
What do these graphs tell us?
– Correlation between default risk and current ratios is low.
Why?
• Efficient firms minimize working capital
• Profitable firms can borrow to overcome short-term
cash shortfalls.
– Current performance is a better predictor of future default
risk. The operating cash flow ratio contains a measure of
current performance (i.e., operating cash flow) and it
seems to have some predictive power
– Firms default on debt when they are unable to run their
operations profitably. Predicting profitability is an
essential part of credit analysis.
Acct 503B Fall 2023
Week 6
27
Measures of Default Probability
Liquidity (example)
(in millions)
Current Assets < Current Liabilities Acct 503B Fall 2023 Week 6 28 Measures of Default Probability Liquidity (example) Company’s (Clorox) liquidity situation looks precarious. – Current ratio is only 0.88 However, – Company is profitable so it can borrow to overcome liquidity problems • Clorox issued $500M of notes maturing in May 2030 at an interest rate of 1.96%. • Company has an A- long-term credit rating. • Company has $1.2B credit line. Profitability of operations is the key to liquidity – Gross profit % is 36% – Operations producing $178M of cash flow in the 9/30/2022 quarter Acct 503B Fall 2023 Week 6 29 Measures of Default Probability Solvency A company’s long-run financial viability and its ability to cover long-term obligations depends on success of operating activities. – Capital structure: Greater leverage implies greater variability in shareholders’ equity; firm has less ability to absorb economic problems • Liabilities to equity ratio Total liabilities/shareholders’ equity • Debt-to-equity ratio Short-term debt + long-term debt/shareholders’ equity • Debt-to-market-value-of-equity ratio Short-term debt + long-term debt/market value of shareholders’ equity Acct 503B Fall 2023 Week 6 30 Measures of Default Probability Solvency/Liquidity (continued) Coverage ratios: provide a measure of the ease with which a firm can meet is interest obligations from current operations. – Interest Coverage (earnings basis) Net income + interest expense + tax expense / interest expense – Interest Coverage (cash flow basis) Cash flow from operations + interest expense + tax paid / interest expense Acct 503B Fall 2023 Week 6 31 Measures of Default Probability Solvency Acct 503B Fall 2023 Week 6 32 Measures of Default Probability Solvency (with banks; higher leverage) Acct 503B Fall 2023 Week 6 33 Measures of Default Probability Solvency Acct 503B Fall 2023 Week 6 34 Measures of Default Probability Solvency Acct 503B Fall 2023 Week 6 35 Measures of Default Probability Solvency/Liquidity Acct 503B Fall 2023 Week 6 36 Measures of Default Probability Solvency/Liquidity Acct 503B Fall 2023 Week 6 37 Interest Coverage Ratio Example Clorox’s lender controls its credit risk exposure by requiring Clorox to maintain an interest coverage ratio greater than 4.0 Acct 503B Fall 2023 Week 6 38 Credit Analysis and Financial Distress Solvency What do these graphs tell us? – We find a correlation between default risk and debt to equity ratios. Why? Acct 503B Fall 2023 Week 6 39 Credit Analysis and Financial Distress Solvency What do these graphs tell us? – We find a correlation between default risk and debt to equity ratios. Why? • High debt relative to equity indicates – higher variability in net income; greater sensitivity of equity value to business cycles. – lower equity cushion to protect bondholders • Market value relative to debt is an excellent predictor – Price of shareholders’ equity incorporates more information about future profitability that does book value of shareholders’ equity. Acct 503B Fall 2023 Week 6 40 Measures of Default Probability Profitability Acct 503B Fall 2023 Week 6 41 Credit Analysis and Financial Distress Profitability What do these graphs tell us? – The correlation between default risk and profitability is not as strong as the correlation between default risk and coverage ratios Why? Acct 503B Fall 2023 Week 6 42 Credit Analysis and Financial Distress Profitability What do these graphs tell us? – The correlation between default risk and profitability is not as strong as the correlation between default risk and coverage ratios Why? • Profitability relative to interest burden is a more precise measure of the default risk of debt than profitability alone. Acct 503B Fall 2023 Week 6 43 Measures of Default Probability Firm Size Acct 503B Fall 2023 Week 6 44 Credit Analysis and Financial Distress Firm Size What do these graphs tell us? – We find a negative correlation between default risk and size Why? Acct 503B Fall 2023 Week 6 45 Credit Analysis and Financial Distress Firm Size What do these graphs tell us? – We find a negative correlation between default risk and size Why? • Bigger firms are less likely to default – Perhaps greater mark share means that the profits of larger firms are less sensitive to economic downturns – Larger firms have a longer history of profitability; they have demonstrated their ability to succeed Acct 503B Fall 2023 Week 6 46 Measures of Default Probability Stock Return Volatility Acct 503B Fall 2023 Week 6 47 Credit Analysis and Financial Distress Stock Return Volatility What does this graph tell us? – We find a positive correlation between default risk and the company’s stock return variance Why? Acct 503B Fall 2023 Week 6 48 Credit Analysis and Financial Distress Stock Return Volatility What does this graph tell us? – We find a positive correlation between default risk and the company’s stock return variance Why? • Greater volatility of shareholders’ equity implies a greater volatility in the firms assets. Thus greater volatility implies an increased chance that the value of the firms assets will be less that the promised payment on the debt. • Shareholders’ equity is acts as a margin of safety against default. Bondholders prefer a margin of safety that is large and stable. Acct 503B Fall 2023 Week 6 49 Looking at all Variables Simultaneously: Determinants of loan spread Ordinary Least Squares regression of bond spread over treasury Variables most strongly related to spread Acct 503B Fall 2023 (Source: Compustat, fiscal 2016; SDC) Week 6 50 Credit Analysis and Financial Distress Bankruptcy Prediction Models Research has produced models that seek to produce a probability of bankruptcy based on historical financial statement information. One commonly used model is The Altman “Z-Score” (1968) The models use fiscal year end data to measure the risk of bankruptcy over the 12-month period beginning 4 months after the firm’s fiscal-year end. KMV model calculates expected default probability using asset value, asset volatility, and leverage. Acct 503B Fall 2023 Week 6 51 Bankruptcy Prediction Models Altman Z-Score The Altman model (updated by Hillegeist et al. 2004) Z Score = -0.08 × WC/TA + 0.04 × Retained earnings/TA + -0.10 × EBIT/TA + -0.10 × Mkt. Value of equity/TL + 0.06 × Sales/TA + -4.34 • Bankruptcy risk is increasing in Z-Score • Bold/italicized coefficients are statistically significant (i.e., significantly different from zero) • The model has an R-Squared of about 6%. Acct 503B Fall 2023 Week 6 52 Bankruptcy Prediction Models Altman Z-Score • To get a probability of bankruptcy, the Z score must be transformed as follows: Prob = ez score / (1+ ez score) – where e ≈ 2.718 • Bankrupt firms have an average Z-Prob of 1.21 • Solvent firms have an average Z-Prob of 0.77 Acct 503B Fall 2023 Week 6 53 Bankruptcy Prediction Models Altman Z-Score • GM’s 2008 Z-Prob pre-bailout WC (Working capital) ≈ TA (Total Assets) Retained earnings EBIT (NI + taxes + int. expense) Market value of equity Sales TL (Total Liabilities) $-19,625 136,404 -58,470 -33,040 3,170 161,290 191,640 Plugging these numbers into the model gives a Z-Score = -3.12 and a Z-Prob = 0.0422 or 4.22% Thus GM’s Z-score indicated it was much more likely that the average firm to go bankrupt in the next 12 months. Acct 503B Fall 2023 Week 6 54 Bankruptcy Prediction Models Altman Z-Score Acct 503B Fall 2023 Week 6 55 Credit Analysis and Financial Distress Conclusion Bondholders focus on the health of current operations rather than growth Default risk is best measured by: – Firm size – Debt-to-equity – Profitability relative to interest payments – Variance of the firm’s common stock The Altman model suggests that profitability and market value of equity relative to liabilities are significantly related to bankruptcy probability Acct 503B Fall 2023 Week 6 56 Investments and Acquisitions Announcements Acct 503B Fall 2023 Week 6 57 Alphabet’s balance sheet and income statement consolidate many independently managed subsidiaries Alphabet is comprised of Google (Search, Android, Chrome, hardware, Cloud, Google Maps, YouTube) and Other Bets (Access, Calico, CapitalG, GV, Nest, Verily, Waymo, and X) Acct 503B Fall 2023 Week 6 58 How much do these subsidiaries contribute? Perhaps, we can understand why shareholders are becoming a bit impatient with Google’s investment decisions. “Cloud” and “Other Bets” lost $8.3B in 2021. Acct 503B Fall 2023 Week 6 59 Investments and Acquisitions The accounting method used for investments depends on the extent to which the investor exerts influence over the investee. The equity method – Investee income (rather than dividends received) affects income recorded in the investor’s financial statements – Tends to increase the investor’s ROA and return on sales, because investee assets are not included in the investor financial statements Consolidated accounting – Consolidation does not affect investors shareholders’ equity – Investee’s assets, liabilities, revenues and expenses are incorporated into the investor’s financial statements. – Understand what “noncontrolling interest” on the B/S and I/S means – Goodwill arises from acquisitions Acct 503B Fall 2023 Week 6 60 Investments in the Stock of Other Companies The accounting method for stock investments depends on the degree of influence the investing company has on the decisions of the investee. Three methods of accounting for this investment: Ownership: 50% Influence: “passive” “significant influence” “controlling” Reporting Method: Mark-tomarket Equity Equity with Consolidation Acct 503B Fall 2023 Week 6 61 Significant Influence  Equity Method Assume the following events 1. Purchase: Investor acquires 48,000 shares amounting to 40% of EE Corporation for $10 per share 2. Dividends: EE Corporation pays a dividend of $60,000 or 50 cents per share 3. Affiliate earnings: EE Corporation Earns $100,000 in Net Income Record these events on Balance sheet of investor company. Cash Long-term Investment = R/E 1. Purchase 2. Dividends 3. Aff. earnings Acct 503B Fall 2023 Week 6 62 Significant Influence  Equity Method Assume the following events 1. Purchase: Investor acquires 48,000 shares amounting to 40% of EE Corporation for $10 per share 2. Dividends: EE Corporation pays a dividend of $60,000 or 50 cents per share 3. Affiliate earnings: EE Corporation Earns $100,000 in Net Income Record these events on Balance sheet of investor company. 1. Purchase 2. Dividends 3. Aff. earnings Cash (480,000) Long-term Investment 480,000 = R/E Acct 503B Fall 2023 Week 6 63 Significant Influence  Equity Method Assume the following events 1. Purchase: Investor acquires 48,000 shares amounting to 40% of EE Corporation for $10 per share 2. Dividends: EE Corporation pays a dividend of $60,000 or 50 cents per share 3. Affiliate earnings: EE Corporation Earns $100,000 in Net Income Record these events on Balance sheet of investor company. 1. Purchase 2. Dividends 3. Aff. earnings Cash (480,000) 24,000 Long-term Investment 480,000 (24,000) = R/E 40% × $60,000 Acct 503B Fall 2023 Week 6 64 Significant Influence  Equity Method Assume the following events 1. Purchase: Investor acquires 48,000 shares amounting to 40% of EE Corporation for $10 per share 2. Dividends: EE Corporation pays a dividend of $60,000 or 50 cents per share 3. Affiliate earnings: EE Corporation Earns $100,000 in Net Income Record these events on Balance sheet of investor company. 1. Purchase 2. Dividends 3. Aff. earnings Cash (480,000) 24,000 Long-term Investment 480,000 (24,000) 40,000 40% × $60,000 40% × $100,000 = R/E 40,000 (inv. inc.) Acct 503B Fall 2023 Week 6 65 Control  Consolidation Method When the investor controls the investee, – The investor corporation becomes a parent. – The investee corporation becomes a subsidiary. – The parent prepares consolidated financial statements that treat the parent and the subsidiary as a single economic entity even though they are separate legal entities. Consolidated financial reporting requires multiple sets of financial records – Each subsidiary maintains its own set of books that are independent of who owns it – Parent prepares consolidation financial statements. Acct 503B Fall 2023 Week 6 66 Consolidation Method: Initial 100% purchase P Co. acquires 100% of S Co.’s stock for $110 cash. Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 Investment in S Consolidated S Co. Adjustment P+S $ 150 + Liabilities S. E. 200 300 40 110 Acct 503B Fall 2023 Week 6 67 Consolidation Method: Initial 100% purchase P Co. acquires 100% of S Co.’s stock for $110 cash. Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 Consolidated S Co. Adjustment P+S $ 150 + Liabilities S. E. 200 300 40 110 Acct 503B Fall 2023 Week 6 68 Consolidation Method: Initial 100% purchase P Co. acquires 100% of S Co.’s stock for $110 cash. Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 Consolidated S Co. Adjustment P+S $ 150 + Liabilities S. E. 200 300 200 300 40 110 Acct 503B Fall 2023 Week 6 69 Consolidation Method: Initial 100% purchase P Co. acquires 100% of S Co.’s stock for $110 cash. Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 Consolidated S Co. Adjustment P+S $ 150 540 –110 0 540 + Liabilities S. E. 200 300 200 300 Eliminated 40 110 240 300 540 –110 Acct 503B Fall 2023 Week 6 70 Consolidation Method: Initial 100% purchase P Co. acquires 100% of S Co.’s stock for $110 cash. Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 Consolidated S Co. Adjustment P+S $ 150 540 –110 0 540 + Liabilities S. E. 200 300 200 300 40 110 240 300 540 –110 Substitute assets and liabs. of S for “Investment in S” Acct 503B Fall 2023 Week 6 71 Consolidation Method: Initial 100% purchase P Co. acquires 100% of S Co.’s stock for $110 cash. Assume the book value of S’s assets, liabilities, and shareholder’s equity equal their market value. P Co. P Co. pre-acq. post-acq. Cash, other assets $ 500 390 Investment in S 110 Consolidated S Co. Adjustment P+S $ 150 540 –110 0 540 + Liabilities S. E. 200 300 200 300 40 110 240 300 540 –110 Acct 503B Fall 2023 “Shareholders’ equity does not increase when you buy something” Week 6 72 Intuition Behind Consolidation Method Assume P Co. buys a $150k truck for $110k cash and a $40k loan. Cash Truck Liabilities S. E. Original Company $ 500 Truck Post-truck Company 150 200 300 40 Where does the $110,000 cash go?  How does the purchase of the truck affect shareholders’ equity?  Acct 503B Fall 2023 Week 6 73 Intuition Behind Consolidation Method Assume P Co. buys a $150k truck for $110k cash and a $40k loan. Cash Truck Liabilities S. E. Original Company $ 500 Truck 150 200 300 40 Post-truck Company 390 500 - 110 150 240 300 Where does the $110,000 cash go?  How does the purchase of the truck affect shareholders’ equity?  Acct 503B Fall 2023 Week 6 74 Intuition Behind Consolidation Method Assume P Co. buys a $150k truck for $110k cash and a $40k loan. Cash Truck Liabilities S. E. Original Company $ 500 Company Truck 150 200 300 40 110 Post-truck Company 390 500 - 110 150 240 300 Where does the $110,000 cash go?  How does the purchase of the truck affect shareholders’ equity?  Acct 503B Fall 2023 Week 6 75 Consolidation: Income Statement P Co. owns 100% of S Co.’s stock. Prepare a consolidated income statement using the following separate income statements for P and S. Sales Expenses Investment income Net income Equity Method P Co. S Co. 600 $ 180 – 450 – 160 150 20 -20 Consolidated Adjustment P+S Acct 503B Fall 2023 Week 6 76 Consolidation: Income Statement P Co. owns 100% of S Co.’s stock. Prepare a consolidated income statement using the following separate income statements for P and S. Sales Expenses Investment income Net income Equity Method P Co. S Co. 600 $ 180 – 450 – 160 150 20 20 -170 20 Consolidated Adjustment P+S Acct 503B Fall 2023 Week 6 77 Consolidation: Income Statement P Co. owns 100% of S Co.’s stock. Prepare a consolidated income statement using the following separate income statements for P and S. Sales Expenses Investment income Net income Equity Method P Co. S Co. 600 $ 180 – 450 – 160 150 20 20 -170 20 Consolidated Adjustment P+S 780 – 610 170 Acct 503B Fall 2023 Week 6 78 Consolidation: Income Statement P Co. owns 100% of S Co.’s stock. Prepare a consolidated income statement using the following separate income statements for P and S. Sales Expenses Investment income Net income Equity Method P Co. S Co. 600 $ 180 – 450 – 160 150 20 20 -170 20 Consolidated Adjustment P+S 780 – 610 170 – 20 0 170 Acct 503B Fall 2023 Week 6 79 Consolidation: