Question

1 Why is it that small businesses often form initially as sole proprietorships, if the corporate form has so many advantages over the sole proprietorship?

2.In developing the cash flow statement, why is depreciation added back to operating cash flows and to fixed assets?

3.What are the assumptions of the sustainable growth rate? What does sustainable growth rate mean?

4.If Corsair, Inc. has an ROE of 17.7 percent and a payout ratio of 18 percent, what is its sustainable growth rate?

Answer 1

(1).

For small businesses generally sole propritorship firms are preferred because if a person starts a corporate form of business organization, there are lot of issues that he/she needs to take care, with respect to compliance to statutory requirements like corporate laws, tax laws etc. Also documentation requirements with respect to transactions, minutes of the meetings, registers that needs to be maintained etc are more when compared to a sole proprietorship firms. Also tax rates applicable for corporates is more when compared to sole proprietorship firms. For small businesses it would be hard and time consuming to maintain the above said requirements both in terms of money and time. so, generally small businesses prefer sole proprietorship than a corporate structure.

(2).

Depreciation moves the cost of an asset to Depreciation Expense during the asset's useful life. The accounts involved in recording depreciation are Depreciation Expense and Accumulated Depreciation. As you can see, cash is not involved. In other words, depreciation reduces net income on the income statement, but it does not reduce the Cash account on the balance sheet.

Because we begin preparing the statement of cash flows using the net income figure taken from the income statement, we need to adjust the net income figure so that it is not reduced by Depreciation Expense. To do this, we add back the amount of the Depreciation Expense.

Depletion Expense and Amortization Expense are accounts similar to Depreciation Expense, as all three involve allocating the cost of a long-term asset to an expense over the useful life of the asset. There is no cash involved.

Simply deprecation is non cash item ,as it decrease the operating profit we added back while preparing cash flow statement to get actual cash involved.

(3).

Assumptions:-

The main assumptions of the sustainable growth rate model include that assets will growth in proportionate to sales, profits will grow constant to sales, the firm has a specified divided policy and a fixed dividend earnings ratio and also that the firm will not alter the number of its outstanding stock.

Sustainable growth rate is the maximum growth rate that a firm can sustain without having to increase the financial leverage or look for outside financing. It is an indication of how large a firm can grow without borrowing more money. After a firm has crossed the sustainable growth rate(SGR), its growth rate declines in the coming years and it must start borrowing to facilitate additional growth.

(4).

Retention ratio = 1-18% = 82%

Sustainable growth rate = ROE×Retention ratio÷(1-ROE×Retention ratio)

= 17.7%×82%÷(1-17.7%×82%)

= 16.98%