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Chapter 2: 2-10DQ (page 46)

Why is interest expense said to cost the firm substantially less than the actual expense, while dividends cost it 100 percent of the outlay?

Short Answer

Expert verified

Interest expense is a tax-deductible item to the company, while the dividend payments are not.So, the actual cost of interest is lower, whereas the actual cost of the dividend is exactly equal to the outlay.

Step by step solution

01

Interest expense 

Interest expense is explained as the cost incurred by an organization on the borrowed amounts. It is a non-operating expense debited in the income statement as an indirect expense.

02

Dividend 

A dividend is a distribution of net income earned by the company during the year to its shareholders.It is paid per-share, either in cash or by issuing a cheque or online transfer.The net cost of the interest expense to the company is the amount paid less the tax saving due to interest paid. However, in the case of dividends paid, there is no tax saving. Hence, the dividend cost is equal to the total outlay.

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Most popular questions from this chapter

Inflation can have significant effects on income statements and balance sheets, and therefore on the calculation of ratios. Discuss the possible impact of inflation on the following ratios, and explain the direction of the impact based on your assumptions.

b. Inventory turnover

Prepare an income statement for Franklin Kite Co. Take your calculations all the way to computing earnings per share.

Sales

$900,000

Shares outstanding

50,000

Cost of goods sold

400,000

Interest expenses

40,000

Selling and administration expenses

60,000

Depreciation expenses

20,000

Preferred stock dividend

80,000

Taxes

50,000

The Lancaster Corporation’s income statement is given below.

b. What would be the fixed-charge-coverage ratio?

Lancaster corporation

Sales

\(246,000

Cost of goods sold

122,000

Gross profit

\)124,000

Fixed charges (other than interest)

27,500

Income before interest and taxes

\(96,500

Interest

21,800

Income before taxes

\)74,700

Taxes (35%)

26,145

Income after taxes

$48,555

For December 31, 20X1, the balance sheet of Baxter Corporation was as follows:

Current assets

Liabilities

Cash

\(15,000

Accounts payable

\)17,000

Accounts receivable

20,000

Notes payable

25,000

Inventory

30,000

Bonds payable

55,000

Prepaid expenses

12,500

Fixed assets

Stockholder’s equity

Plant and equipment (gross)

Less: accumulated depreciation

\(255,000

51,000

Preferred stock

\)25,000

Net plant and equipment

\(204,000

Common stock

60,000

Paid in capital

30,000

Retained earnings

69,500

Total assets

\)281,500

Total liabilities and stockholder’s equity

\(281,500

Sales for 20X2 were \)245,000, and the cost of goods sold was 60 percent of sales. Selling and administrative expense was \(24,500. Depreciation expense was 8 percent of plant and equipment (gross) at the beginning of the year. Interest expense for the notes payable was 10 percent, while the interest rate on the bonds payable was 12 percent. This interest expense is based on December 31, 20X1 balances. The tax rate averaged 20 percent.

\)2,500 in preferred stock dividends were paid, and \(5,500 in dividends were paid to common stockholders. There were 10,000 shares of common stock outstanding.

During 20X2, the cash balance and prepaid expenses balances were

unchanged. Accounts receivable and inventory increased by 10 percent. A new machine was purchased on December 31, 20X2, at a cost of \)40,000. Accounts payable increased by 20 percent. Notes payable increased by \(6,500 and bonds payable decreased by \)12,500, both at the end of the year. The preferred stock, common stock, and paid-in capital in excess of par accounts did not change.

c. Prepare a balance sheet as of December 31, 20X2.

Low Carb Diet Supplement Inc. has two divisions. Division A has a profit of\(156,000 on sales of \)2,010,000. Division B is able to make only \(28,800 onsales of \)329,000. Based on the profit margins (returns on sales), which divisionis superior?
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