Question

Effect of Investing on Ratios
DeFond Company wishes to secure a reliable supply of a key component for its production processes, and its management is considering two alternative investments. Verduzco Company produces exactly the supply that DeFond needs, so DeFond could use cash to purchase 100% of the common stock of Verduzco. Lin Company produces twice as much of the component that DeFond needs, but DeFond could form a joint venture with another company where each would purchase 50% of Lin Company's common stock and each take 50% of Lin Company's output.

The table that follows gives the balance sheet information for all three companies prior to any investment by DeFond. For the questions below, assume that DeFond would be able to purchase shares at the investee companies' book values and that the investee companies' assets and liabilities have fair values equal to their book values.

			DeFond Company	Verduzco Company	Lin Company
Cash			$800	$100	$200
Investment			-	-	-
Noncash assets			2,000	900	1,800
Liabilities			2,200	700	1,400
Shareholders' Equity			600	300	600

a. Suppose that DeFond purchases 100% of Verduzco's common stock for $300. Produce the consolidated balance sheet for DeFond immediately after the acquisition.

Defond Company Consolidated Balance sheet
Current assets	$Answer
Investments	Answer
Noncash assets	Answer
Total assets	$Answer
Liabilities	$Answer
Shareholders' equity	Answer
Total liabilites & Shareholders' equity	$Answer

b. Suppose that DeFond purchases 50% of Lin's common stock for $300. Produce the balance sheet for DeFond immediately after the investment (using the equity method).

Defond Company Consolidated Balance sheet
Current assets	$Answer
Investments	Answer
Noncash assets	Answer
Total assets	$Answer
Liabilities	$Answer
Shareholders' equity	Answer
Total liabilites & Shareholders' equity	$Answer

c. From a business perspective, either of these investments will accomplish the objective of obtaining a reliable supply of components. How will the financial ratios differ between the two alternatives?

Debt-to-Equity ratio will not change whether DeFond purchases the subsidiary or invests in the joint venture.

Debt-to-Equity ratio will be higher if DeFond purchases the subsidiary rather than investing in the joint venture.

Debt-to-Equity ratio will be lower if DeFond purchases the subsidiary rather than investing in the joint venture.

Answer 1

Part A

Consolidated reports

	DeFond company (before investment)	DeFond company (after investment)	Verduzco company	Eliminating entries	DeFond company (Consolidated)
Current assets	800	500	100		600
Investment		300		(300)
Noncurrent assets	2000	2000	900		2900
Liabilities	2200	2200	700		2900
Shareholders’ equity	600	600	300	(300)	600

DeFond Company

Consolidated Balance Sheet

Current assets	600
Investment	0
Noncurrent assets	2900
Total assets	3500
Liabilities	2900
Shareholders’ equity	600
Total liabilities and shareholders’ equity	3500

Part B

	DeFond company (before investment)	DeFond company (after investment)	Lin company	DeFond company (Consolidated)
Current assets	800	500	200	700
Investment		300		300
Noncurrent assets	2000	2000	1800	3800
Liabilities	2200	2200	1400	3600
Shareholders’ equity	600	600	600	1200

DeFond Company

Consolidated Balance Sheet

Current assets	700
Investment	300
Noncurrent assets	3800
Total assets	4800
Liabilities	3600
Shareholders’ equity	1200
Total liabilities and shareholders’ equity	4800

Part C

Total assets and liabilities are higher in case of consolidated balance sheet according to the equity method. Therefore, Debt-to-Equity ratio will be higher if DeFond purchases the subsidiary rather than investing in the joint venture. Thus, answer is option B