Chapter 2, Problem 1Q

a)

Summary Introduction

To discuss: Annual report, income statement and balance sheet.

Explanation of Solution

Annual report is nothing but the report issued by company to its shareholders annually. It contains financial statements like balance sheet, income statement, statement of cash flows and statement of stockholders’ equity.

Balance sheet is one of the financial statements that show firm’s financial position as on a particular date. Income statement represents financial performance of the firm during a particular period of time (usually one year). It reports expenses and revenues over a particular period of time.

b)

Summary Introduction

To discuss: Common stockholders’ equity or net worth and retained earnings.

Explanation of Solution

Common stockholders’ equity or net worth is the capital contains company’s capital stock, retained earnings and capital reserves. Retained earnings signify that the company’s accumulated net income retained by company for a particular point of time. Mostly, retained earnings could be used on firm’s operating assets like as buildings and equipment.

c)

Summary Introduction

To discuss: Cash flow statement and statement of stockholders’ equity.

Explanation of Solution

Statement of stockholders’ equity shows the amount of earnings retained with the company rather than distributed as dividends. It indicates the final resulting balance of stockholders’ equity account and retained earnings account.

Statement of cash flows contains three activities which will impact cash flows of company over a period of time (one year). The three activities are, operating, investing and financing activities.

d)

Summary Introduction

To discuss: Amortization, depreciation and EBITDA.

Explanation of Solution

Depreciation is nothing but the reduction of value of an asset. It is treated as non-cash expenses and charged against tangible assets like buildings, equipment.

Amortization is charged against intangible assets like patents and goodwill. EBITDA is nothing but earnings before interest, taxes, depreciation and amortization.

e)

Summary Introduction

To discuss: Operating current assets, operating current liabilities, total net operating capital and net operating working capital.

Explanation of Solution

Operating current assets are the current assets that are used to support the company in its business operations. The assets include inventory, cash and accounts receivables, but it doesn’t include short term investments.

Operating current liabilities are the usual outcome of the firm’s operations. It includes accounts payables and accruals but doesn’t include notes payables and short term debt charges.

Net operating working capital is nothing but the difference between operating current assets minus operating current liabilities.

Total net operating capital is nothing the total addition on total net operating working capital and total operating long-term assets like plant and equipment.

f)

Summary Introduction

To discuss: Accounting profit, net cash flow, free cash flow, NOPAT and return on invested capital.

Explanation of Solution

Accounting profit is nothing but net income reported in firm’s income statement. Net cash flow is opposite to accounting net income, it is nothing but total net income of the firm added some non-cash adjustments.

NOPAT is the net operating profit after taxes produced by company when it has no financial assets and no debt. Free cash flows are actually available for investors to distribute only after the firm has made all of its investments in working capital and fixed assets essentially to maintain on-going operations of the business.

Return on invested capital (ROIC) shows the return generated by company’s assets and it is measured by dividing NOPAT with total operating capital.

g)

Summary Introduction

To discuss: Market value added and economic value added.

Explanation of Solution

Market value added is nothing but the difference between market value of the firm and to its book value of common equity, preferred stock and debt of the company.

Economic value added is the residual income remained after deducting all costs of capital including cost of equity of the company.

h)

Summary Introduction

To discuss: Progressive tax, taxable income, average and marginal tax rates.

Explanation of Solution

Progressive tax means the higher one’s earnings, the higher the income the larger percentage of taxes paid.

Taxable income is nothing but the income which is chargeable as per income tax rules after deducting certain exemptions and deductions. Margin tax rate is the tax rate on the ultimate unit of income. Average tax rate is calculated by dividing total taxes paid with total taxable income.

i)

Summary Introduction

To discuss: Meaning of capital gain or loss and tax loss carry forward.

Explanation of Solution

The concept of capital gain or loss will be comes to picture while selling a capital asset more than of its original purchase price. Ordinary corporate operating losses can be used to set off future taxable income; those losses can be carried backward only for 2 years and forward for indefinite period.

j)

Summary Introduction

To discuss: Improper accumulation and S corporation.

Explanation of Solution

Improper accumulation is the process of retaining the earnings with company to enable its stockholders to evade from personal income taxes on dividends.

S corporation is the small corporation, based on Internal Revenue code. It is decided to be taxed as a sole proprietorship or a partnership and having a limited liability and other form of benefits as per company form of organization.