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Q20E.

Expert-verified
Intermediate Accounting (Kieso)
Found in: Page 817

Short Answer

(Trading on the Equity Analysis) Presented below is information from the annual report of Emporia Plastics, Inc.

Operating income

$ 532,150

Bond interest expense

135,000

397,150

Income taxes

183,432

Net income

$ 213,718

Bonds payable

$1,000,000

Common stock

875,000

Retained earnings

375,000

Instructions

  1. Compute the return on common stockholders’ equity and the rate of interest paid on bonds. (Assume balances for debt and equity accounts approximate averages for the year.)
  2. Is Emporia Plastics, Inc. trading on the equity successfully? Explain.

The rate of return on common stock equity is 17.1%, and the rate of interest on bonds payable is 13.5%.

See the step by step solution

Step by Step Solution

Meaning of Equity

Equity represents the value derived by the owners. Based on the company's balance sheet, the value of equity is determined as the difference between assets and liabilities. The market value of equity is determined by either the existing share price (if publicly traded) or by the valuation of a professional.

Computing the return on common stockholders’ equity and the rates of interest paid on bonds.

Explaining the trading on the equity of Emporia Plastics, Inc.

Emporia Plastics, Inc. is trading on the equity successfully since its return on common stock equity is greater than the interest paid on bonds.

Note: Some analysts use after-tax interest expense to compute the bond rate.

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