"Chapter 2Discussion Questions 2-1. Discuss some financial variables that affect the price-earnings ratio.The price-earnings ratio will be influenced by the earnings and sales growth ofthe firm, the risk or volatility in performance, the debt-equity structure of thefirm, the dividend payment policy, the quality of management, and a number ofother factors. The ratio tends to be future-oriented, and the more positive theoutlook, the higher it will be. 2-2. What is the difference between book value per share of common stock andmarket value per share? Why does this disparity occur?Book value per share is arrived at by taking the cost of the assets andsubtracting out liabilities and preferred stock and dividing by the number ofcommon shares outstanding. It is based on the historical cost of the assets.Market value per share is based on current assessed value of the firm in themarketplace and may bear little relationship to original cost. Besides thedisparity between book and market value caused by the historical cost approach,other contributing factors are the growth prospects for the firm, the quality ofmanagement, and the industry outlook. To the extent these are quite negative orpositive; market value may differ widely from book value. 2-3. Explain how depreciation generates actual cash flows for the company.The only way depreciation generates cash flows for the company is by servingas a tax shield against reported income. This non-cash deduction may providecash flow equal to the tax rate times the depreciation charged. This much intaxes will be saved, while no cash payments occur. 2-4. What is the difference between accumulated depreciation and depreciationexpense? How are they related?Accumulated depreciation is the sum of all past and present depreciationcharges, while depreciation expense is the current year’s charge. They arerelated in that the sum of all prior depreciation expense should be equal toaccumulated depreciation (subject to some differential related to asset write- offs). S2-1 2-5. How is the income statement related to the balance sheet?The earnings (less dividends) reported in the income statement is transferred tothe ownership section of the balance sheet as retained earnings. Thus, what weearn in the income statement becomes part of the ownership interest in thebalance sheet. 2-6. Comment on why inflation may restrict the usefulness of the balance sheet asnormally presented.The balance sheet is based on historical costs. When prices are rising rapidly,historical cost data may lose much of their meaning ?p equipment and inventory. 2-7. Explain why the statement of cash flows provides useful information that goesbeyond income statement and balance sheet data.The income statement and balance sheet are based on the accrual method ofaccounting, which attempts to match revenues and expenses in the period inwhich they occur. However, accrual accounting does not attempt to properlyassess the cash flow position of the firm. The statement of cash flows fulfillsthis need. 2-8. What are the three primary sections of the statement of cash flows? In whatsection would the payment of a cash dividend be shown?The sections of the statement of cash flows are:Cash flows from operating activitiesCash flows from investing activitiesCash flows from financing activitiesThe payment of cash dividends falls into the financing activities category. S2-2 2-9. What is free cash flow? Why is it important to leveraged buyouts?Free cash flow is equal to cash flow from operating activities:Minus: Capital expenditures required to maintain the productive capacityof the firm.Minus: Dividends (required to maintain the payout on common stock andto cover any preferred stock obligation).The analyst or banker normally looks at free cash flow to determine whetherthere are sufficient excess funds to pay back the loan associated with theleveraged buy-out. 2-10. Why is interest expense said to cost the firm substantially less than the actualexpense, while dividends cost it 100 percent of the outlay?Interest expense is a tax deductible item to the corporation, while dividendpayments are not. The net cost to the corporation of interest expense is theamount paid multiplied by the difference of one minus the applicable tax rate.For example, $100 of interest expense costs the company $65 after taxes whenthe corporate tax rate is 35 percent; for example, $100 × (1? .35) =S2-3 Chapter 2Problems1. Rockwell Paper Company had earnings after taxes of $580,000 in the year 2007 with400,000 shares of stock outstanding. On January 1, 2008, the firm issued 35,000 newshares. Because of the proceeds from these new shares and other operating improvements,earnings after taxes increased by 25 percent. a. Compute earnings per share for the year 2007. b. Compute earnings per share for the year 2008.2-1. Solution:Rockwell Paper Companya. Year 2007Earnings after taxes Earnings per share =Shares outstanding $580,000 == $1.45 400,000 b. Year 2008Earnings after taxes= $580,000 ×= 1.25 $725,000 Shares outstanding= $400,000 += 35,000 $435,000 $725,000 Earnings per share = = $1.67 $435,000 S2-4 2. Sosa Diet Supplements had earnings after taxes of $800,000 in the year 2008 with 200,000shares of stock outstanding. On January 1, 2009, the firm issued 50,000 new shares.Because of the proceeds from these new shares and other operating improvements, earningsafter taxes increased by 30 percent. a. Compute earnings per share for the year 2008. b. Compute earnings per share for the year 2009.2-2. Solution:Sosa Diet Supplementsa. Year 2008Earnings after taxes Earnings per share = Shares outstanding $800,000 == $4.00 200,000 b. Year 2009Earnings after taxes = $800,000 ×=1.30$1,040,000 Shares outstanding = 200,000 + 50,000 = 250,000$1,040,000 Earning per share = =$4.16 250,000 S2-5 "