Ran into this question in my Qbank today: Jill Brown, CFA, is preparing a research report on Kendall Koatings, a maker of paint and industrial insulators. She has learned that Kendall is trying to avert a strike. Contentious labor talks have been ongoing for months. The company is also lobbying the federal government for a tax break in an effort to fend off foreign competition. Most Kendall executives own substantial blocks of stock, and all of them receive at least half of their compensation in the form of stock options. Lastly, one of Kendall’s lines of credit is up for renewal, and the company is trying to negotiate better terms. Several of Kendall’s top managers have a history of manipulating financial results. Based on her observations, which action is Kendall most likely to take? A) Assume that equipment has a useful life of eight years, rather than the five years currently assumed. B) Recognize revenue early. C) Treat all leases as operating leases. The answer is C, as it lowers earnings, which gives the company an advantage in the problems it’s facing. What I don’t get is why having lower earnings gives the company an advantage in negotiating credit terms. I would think the opposite would be true. Can anyone connect the dots for me on this? -Cubemonkey
Sometimes lowering earnings when labor strikes are going on (or aversion of strikes as stated above) gives the labor unions less ammunition to demand higher wages. It seems like if they can avert the strike by lowering earnings, they can avoid higher labor expenses, and avoid further internal strife, which all might look favorably when the credit analysts are doing their analysis. Seems like a tricky/shady question though.
A- you stretch out the useful life, lower depreciation costs, higher earnings, higher taxes paid (question does say that the company is looking for tax breaks so doesn’t feel great) B- recognize revs early- (again, you’d pay higher taxes, would definitely screw you down the line having to pay the piper and these guys are paid in stock option so you maybe don’t want to do that) C- if you treat all leases as operating leases, i would’ve first thought of the path saying you’d improve your ratios and when negotiating for a new credit line, i’m sure that financial ratios are a consideration so it feels like that sketchy move fits what they’re trying to accomplish i think i would’ve picked C here given the 3 choices, but not sure i think this is the best question ever written
lower debt (since you do not have the Present value of Minimum lease payments sitting on the books.) … so a higher d/e ratio - would lead to better credit rating
^ you mean lower D/E ratio leading to better credit rating that’s the line i was thinking… better ratios lead to the better ratings/or ability to get better terms negotiating the new credit line b/c company seems more financially sound.
yes… lower D/E sorry about the typo.
Remember that the underwriting associated with a LOC or any other senior credit facility is based on cash flow not earnings…