10DQ Why is interest expense said to ... [FREE SOLUTION]

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Foundations Of Financial Management

Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen

Business Studies

16th Edition 路 768 pages

ISBN: 9781259277160

Chapter 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

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.

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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January	\(15,000	May	\)15,000
February	17,000	June	21,000
March	19,000	July	23,000
April	25,000

Indicate whether item is on Balance sheet (BS) or Income statement (IS)	If on Balance sheet, designate which category	Item
		Accounts receivable
		Retained earnings
		Income tax expense
		Accrued expense
		Cash
		Selling and administrative expenses
		Plant and equipment
		Operating expenses
		Marketable securities
		Interest expense
		Sales
		Notes payable (6 month)
		Bonds payable, maturity 2019
		Common stock
		Depreciation expense
		Inventories
		Capital in excess of par value
		Net income (earning after tax)
		Income tax payable

JONES CORPORATION
Current assets		Liabilities
Cash	\(20,000	Accounts payable	\)100,000
Accounts receivable	80,000	Bonds payable (long term)	80,000
Inventory	50,000
Long Term Assets		Stockholder鈥檚 Equity
Fixeed assets	\(500,000	Common Stock	\)150,000
Less: Accumulated Depreciation	(150,000)	Paid in capital	70,000
Net fixed assets*	350,000	Retained earnings	100,000
Total assets	\(500,000	Total Liab. And equity	\)500,000

JONES CORPORATION
Sales (on credit)	\(1,250,000
Cost of goods sold	750,000
Gross profit	\)500,000
Selling and administrative expenses	257,000
Less: depreciation expenses	50,000
Operating profits	\(193,000
Interest expenses	8,000
Earning before taxes	\)185,000
Tax expenses	92,500
Net income	\(92,500

SMITH CORPORATION
Current assets		Liabilities
Cash	\(35,000	Accounts payable	\)75,000
Marketable securities	7,500	Bonds payable (long term)	210,000
Accounts receivable	70,000
Inventory	75,000
Long term assets		Stockholder鈥檚 equity
Fixed assets	\(500,000	Common stock	\)75,000
Less: accumulated depreciation	250,000	Paid in capital	30,000
Net fixed assets*	250,000	Retained earnings	47,500
Total assets	\(437,500	Total liab. And equity	\)437,500

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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

Step by step solution

Interest expense

Dividend

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SMITH CORPORATION
Sales (on credit)	\(1,000,000
Cost of goods sold	600,000
Gross profit	\)400,000
Selling and administrative expenses	224,000
Less: depreciation expenses	50,000
Operating profits	\(126,000
Interest expenses	21,000
Earning before taxes	\)105,000
Tax expenses	52,500
Net income	\(52,500

Sales (credit)	$3,549,000
Cash	179,000
Inventory	911,000
Current liabilities	788,000
Assets turnover	1.40 times
Current ratio	2.95 times
Debt-to-assets ratio	40%
Receivables turnover	7 times