Question

Company Baldwin invested $41,740,000 in plant and equipment last year. The plant investment was funded with bonds at a face value of $28,673,042 at 13.8% interest, and equity of $13,066,958. Depreciation is 15 years straight line. For this transaction alone which of the following statements are true?

Select: 5

On the Balance sheet, Long Term Debt changed by $28,673,042.

Since the new plant was funded with debt and equity, on the Balance sheet Retained Earnings decreased by $13,066,958, the difference between the investment $41,740,000 and the bond $28,673,042.

On the Balance sheet, Plant & Equipment increased by $41,740,000.

Cash went down by $41,740,000 when the plant was purchased.

Buying the plant had no net effect on the Cash account, because the plant was paid for by the bond plus retained earnings.

Cash was pulled from retained earnings to cover the $13,066,958 difference between the plant purchase and bond issue.

Depreciation increased by $2,782,667.

Cash went up when the Bond was issued by $28,673,042.

Answer 1

Investment in plant and equipment = $41,740,000

Depreciation for 15 years, implying the life of plant and equipment is 15 years

Funded by bonds = $28,673,042

Funded by equity = $13,066,958

Entries passed:

1. Issue of bonds:

Dr Cash $28,673,042

Cr Bonds (Long term Debts) $28,673,042

2. Issue of equity:

Dr Cash $13,066,958

Cr Equity $13,066,958

3. Purchase of plant:

Dr Plant $41,740,000

Cr Cash $41,740,000

4. Depreciation on plant

Dr Depreciation $2,782,667 (assuming plant is purchased at the beginning of last year = $41,740,000/15)

Cr Provision for Depreciation/Accumulated Depreciation $2,782,667

Basis the above entries, lets see if the followin statements are true:

1. On the Balance sheet, Long Term Debt changed by $28,673,042.

This statement is true. Investment in plant and equipment (having a life of 15 years) is a long term and capital investment and hence the bonds issued to fund these capital investment will also be issued for a long term. Thus, these issue of bonds gets categorised as Long Term Debt and hence the Long term debt changed by $28,673,042 on the balance sheet .

2. Since the new plant was funded with debt and equity, on the Balance sheet Retained Earnings decreased by $13,066,958, the difference between the investment $41,740,000 and the bond $28,673,042.

This statement is not true. The New plant was funded with debt and equity. Funding by equity represent new issue of shares without using the retained earnings. Thus,there will be a change in only long term debt and equity capital and not in retained earnings.

3. On the Balance sheet, Plant & Equipment increased by $41,740,000.

This statement is true. Purchase of plant and equipment for $41,740,000 increases the value of plant & equipment in balance sheet by $41,740,000.

4. Cash went down by $41,740,000 when the plant was purchased.

This statement is true. Issue of new equity and bonds would result in increase in cash and when the plant was purchased, cash reduces to the extent of purchase cost of the plant.

5. Buying the plant had no net effect on the Cash account, because the plant was paid for by the bond plus retained earnings.

This statement is not true. The plant was paid for by the bond plus equity and hence there is no relevance of retained earning. However, a part of the statement that there is no net effect on cash account is true as the proceeds from issue of bonds and equity will first hit cash but when the purchase is made for the same value, cash gets reduced. Thus, there is no net effect on cash account on the balance sheet.

6. Cash was pulled from retained earnings to cover the $13,066,958 difference between the plant purchase and bond issue.

This statement is not true. The New plant was funded with debt and equity. Funding by equity represent new issue of shares without using the retained earnings.Thus, cash was not pulled from retained earnings.

7. Depreciation increased by $2,782,667.

This statement is true. Cost of the new plant purchased is $41,740,000. Depreciation is for 15 years on straight line basis. Depreciation per year = $41,740,000 / 15 = $2,782,667. However, this assumes that the new plant was purchased at the beginning of last year.

8. Cash went up when the Bond was issued by $28,673,042.

This statement is true. When the bond was issued for $28,673,042, company would have received cash first against the bonds issued.