# Question

You are a senior portfolio manager with Reilly Investment Management reviewing the biweekly printout of equity value screens prepared by a brokerage firm. One of the screens used to identify companies is a "low long-term debt/total long-term capital ratio." The printout indicates this ratio for Lubbock Corporation is 23.9%. Your reaction is that Lubbock might be a potential takeover target and you proceed to analyze Lubbock's balance sheet reproduced below:
LUBBOCK CORPORATION
Condensed Balance Sheet (\$ millions)
December 31, Year 7
Assets
Cash and equivalents. . . . . . . . . . . . . . . . . . . . . . . . . . . . . \$ 100
Receivables. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Inventory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Total current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800
Plant and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .\$3,600
Liabilities and Equity
Note payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \$ 125
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
Taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 150
Other current liabilities. . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . 525
Long-term debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 675
Deferred taxes (noncurrent). . . . . . . . . . . . . . . . . . . . . . . . . 175
Other noncurrent liabilities. . . . . . . . . . . . . . . . . . . . . . . . . 75
Minority interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100
Common stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,650
Total liabilities and equity. . . . . . . . . . . . . . . . . . . . . . . . \$3,600
Further analysis of Lubbock's financial statements reveals the following notes:
1. A subsidiary, Lubbock Property Corp., holds, as joint venture partner, a 50% interest in its head office building in Chicago, and 10 regional shopping centers in the United States. The parent company has guaranteed the indebtedness of these properties, which total \$250,000,000 at December 31, Year 7.
2. The LIFO cost basis was used in the valuation of inventories at December 31, Year 7. If the FIFO method of inventory was used in place of LIFO, inventories would have exceeded reported amounts by \$200,000,000.
3. The company leases most of its facilities under long-term contracts. These leases are categorized as operating leases for accounting purposes. Future minimum rental payments as of December 31, Year 7 are: \$90,000,000 per year for Year 8 through Year 27. These leases carry an implicit interest rate factor of 10%, which translates to a present value of approximately \$750,000,000.

Required:
a. Explain how the information in each note is used to adjust items on Lubbock's balance sheet.
b. Calculate an adjusted long-term debt to total long-term capitalization ratio applying the proposed adjustments from (a). Ignore potential income tax effects.
c. As a potential investor, you consider other accounting factors in evaluating Lubbock's balance sheet including:
(1) Valuation of marketable securities.
(2) Treatment of deferred taxes.
Discuss how each of these accounting factors can impact Lubbock's long-term debt to total long-term capitalization ratio.

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