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Unformatted text preview: CHAPTER 2 Understanding Financial Statements, Taxes, and Cash Flows Homework Solutions ANSWERS TO END-OF-CHAPTER QUESTIONS 2-1. a. The balance sheet represents an enumeration of a firms resources (assets) along with its liabilities and owners equity at a given date. The income statement summarizes the net results of the operation of a firm over a specified time interval. The primary distinction between these two statements is that the balance sheet shows the financial condition of a firm at a given date, whereas the income statement deals with the revenues and expenses of the firm incurred during a specified period of time. b. The conventional cash flow statement as prepared by accountants provides the information we need to know about what has happened to the firms cash and why. But it does not present it in a way that makes clear the cash flows the firms creditors and investors are providing to or receiving from the firm. Thus, we choose to reformat the presentation to show the firms free cash flowsthe cash available to distribute to the creditors and investors. We are more interested in considering cash flows from the perspective of the firms shareholders and its investors, rather than from an accounting view. We instead measure the cash flow that is free and available to be distributed to the firms investors, both debt and equity investors, or what we will call free cash flows . Thus, what we use is similar to a conventional cash flow statement presented as part of a companys financial statements, but not exactly. We also make the distinction between the cash flows generated by the firms assets and the financing free cash flows. 2-2. Gross profits is sales less the cost of producing or acquiring the firms product or service. Operating profits is the gross profits less the operating expenses, which consist of distributing the product or service to the customer (namely, marketing expenses) and any general and administrative expenses in operating the business. Net income is operating profits less financing costs (interest expenses and preferred stock dividends) and less income taxes. 2-3. Interest expense is the cost of borrowing money from a banker or another lender. There typically is a fixed interest rate so that the interest expense is computed as the 9 interest rate times the amount borrowed. If we borrow $500,000 at an interest rate of 12 percent, then our interest expense will be $60,000. While interest is paid for the use of debt capital, dividends are paid to the firms stockholders. Preferred stock typically has a fixed dividend rate, so that the preferred stockholder gets a constant dividend each year. Common stockholders, on the other hand, usually receive dividends only if management decides to pay a dividend instead of reinvesting the firms profits. However, typically once a dividend has been paid to common stockholders, management is reluctant to decrease it or cease paying a dividend....
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- Spring '11