Chapter 3 (4,7,12, P6)

4) Explain the following statement: While the balance sheet can be thought of as a snapshot of
a firm’s financial position at a point in time, the income statement reports on operations over a
period of time.

The balance sheet is motionless, it is a snapshot of what the company owns and owes,
and it is motionless. The income statement shows the profitability, sales and costs of a firm
over a period of time. The period of income statement may differ from company to company.
This is why the heading for the income statement is “income statement for the year ending.”
The income statement reports on operations over a period of time rather than a particular
point of time like the Balance Sheet. For example, the income statement represents the
company’s financial performance over a period like a fiscal year.

7) What is free cash flow? If you were an investor, why might you be more interested in free
cash flow than net income?

Free cash flow is the net income –depreciations – capital expenditure. It is the available
cash for distribution among all security holders of an organization. Being an investor I would
favor Free cash flow over net income because it is very difficult to manipulate free cash flows
because it is subject to the accounting practices and principles. Secondly, there is a possibility
that net income is positive, and free cash flow is negative, which is highly valued by all types of
investors.

12) How does the deductibility of interest and dividends by the paying corporations affect the
choice of financing?

Interest is the income paid to the debenture holders of a company. Debentures have no
voting rights, but they have the right to get fixed interests on loans or debt. Dividend is the
income paid to the shareholders of the company. Dividends are not taxed exempt, while
interest paid to debenture holders is taxed exempt. This encourages the use of debt rather than
equity because interest paid is tax deductible but dividend payments are not. The after tax cost
of debt is lower than that of equity.