FINANCIAL STATEMENT ANALYSIS MSc Finance
SOLUTIONS
Tutorials week commencing 14th December 2009
1. The Bowie Company
The most simplistic approach to this question would involve adjusting Bowie’s debt by increasing it with respect
to the (present) value of obligations associated with each of the items mentioned in the notes.
Thus increase debt by 20 + 5 + 7 = £32 m (i.e. the present value of the obligations associated with the lease +
the amount of the loan guaranteed + the present value of the obligations to buy from supplier). Since there is no
effect on equity, the adjusted debt/equity ratio is 2.2 (rather than 0.6). Gearing appears much higher.
b) Reasons for entering into these off-balance sheet commitments:
1. Avoidance of or mitigation of the risk of violating debt covenant restrictions (i.e. lenders often put a clause in
their contracts which oblige borrowers to repay their loans in full if their debt/equity ratio rises above a specific
point).
2. In the case of operating leases, leased assets revert to lessor after eight years, limiting the risk of obsolescence
(i.e. having assets in the balance sheet which are depreciating and yet no longer have any value for the
company).
3. The decision to guarantee Crockett’s borrowing may lower the interest charged on this borrowing, thus
increasing the profitability of a subsidiary. These benefits could be passed on to Bowie through an advantageous
transfer pricing arrangement.
4. The long-term contract with PEPE may secure the supply of an integral component in Bowie’s operations and
give them the leverage to demand a better deal on price or quality. These advantages would be over and above
those already gained from bulk buying etc.
