Question

Please Answer the questions:

1. What is the difference between book value and market value? Which should we use for decision making purposes?

2. What is the difference between accounting income and cash flow? Which do we need to use when making decisions?

3. What is the difference between average and marginal tax rates? Which should we use when making financial decisions?

4. How do we determine a firm’s cash flows? What are the equations, and where do we find the information?

Answer 1

1. Book value levels to the historical cost of assets and liabilities in the balance sheet while market value refers to the market price of shares assets and liabilities. For decision making purposes we use market value because that represents the actual cost to the company.

2. Accounting income refers to the net income as per income statement and all surplus remaining after accounting for revenues and expenses as per the double entry system of accounting. Cash flow refers to the cash movements which relate to changes in working capital fixed assets and adding back of depreciation. For decision making we use cash flows because that represents the actual cash inflow and outflow because of taking a particular decision.

3. Average tax refers to total tax divided by taxable income while marginal tax refers to the additional tax rate on additional income. For decisions purposes we use marginal tax because it allows us to assess the additional tax that will be applicable according to a particular decision.

4. The firm's cash flows are determined by calculating changes in working capital and adjusting net income for non cash expenses such as depreciation.

Cash flow from operations= net income plus non cash expenses minus increase in working capital.

The information is derived from income statement and balance sheet.