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Question

Question 1: [Theory] Understanding financial statements

Question 2: [Theory] Risk and return

Solution

Question 1 [Theory] Understanding financial statements

Part 1:

Balance sheet measures the level of assets, liability and shareholders' equity of a company at the end of the financial year (White, Sondh, & Fried, 2005). Balance sheet consists of assets that are owned by the company, equity that is contributed by promoters as a residual share of ownership and liabilities, which are bank loans and bonds issued by the company (Pittelkow, 2011). On the other hand, an Income statement measures the flow of money into (Revenue) and out of (Expenses) the business in a given financial year (White et al., 2005).

Both the balance sheet and income statement are linked to each other as the net income of the previous year is added to the shareholders’ equity of the current year (Pittelkow, 2011). As a company keeps on earning income, its total shareholders’ equity increases, and so does the asset base (Pittelkow, 2011). Both balance sheet and income statement indicate the financial health of a company and are used by shareholders, creditors, analysts and other major stakeholders for making key decisions (Frank, & Goyal, 2009).

Part 2:

Both debt and equity investors expect a certain return on their investment which is provided to them by the firm in the form of regular interest payments and dividends respectively (Drake, & Fabozzi, 2010). Firms raise debt and equity to a certain ratio so as to minimize their cost of capital. However, most firms enjoy little flexibility in allocating total capital requirement to debt or equity (Drake et al., 2010).

Interest payments are fixed and have to be paid at regular intervals irrespective of the firm’s earnings, whereas dividends payments to shareholders are solely based on the decision of the firm’s board (Brigham, & Ehrhardt, 2013). Therefore paying dividends instead of debt offers flexibility to firms in terms of timing and amount to be paid to investors. However, interest payments are tax-deductible, whereas dividends are not, leading to tax shields if a firm pays interest payments (Ferro, 2012).