a. Prepare an income statement and statement of cash Ous financing proposals h.

Question

a. Prepare an income statement and statement of cash Ous financing proposals h. Write a short memorandum explaining why one financing alternative provides more come but less cash flow than the other ATC 10-7 Ethical Dilemma I don't want to pay taxes Dana Harbert recently started a very successful small business. Indeed, the business had grown so rapidly that she was no longer able to finance its operations by investing her own resou in the business. She needed additional capital but had no more of her own money to put into riend, Gene Watson, was willing to invest $100,000 in the business. Harbert ncrease revenue by estimated that with Watson's investment, the company would be able to i S40,000. Furthermore, she believed that operating expenses would increase by on Harbert and Watson agree that Watson's investment should entitle him to receive a casn equal to 20 percent of net income. A set of forecasted statements with and without s investment is presented here. (Assume that all transactions involving revenue dividend expense, and dividends are cash transactions.) Financial Statements Forecast 2 Forecast 1 without Watson's Investment with Watson's Investment Income Statements $160,000 (77,000) Revenue Operating expenses Income before interest and taxes income tax expense (effective tax rate is 30%) Net income $120,000 0,000) (15,000) S 35,000 S 58,100 Statements of Changes in Stockholders' Equity Beginning retained earnings Plus: Net income Less: Dividend to Watson (20% of S58, 100) Ending retained earnings $ 15,000 35,000 S 15,000 58,100 50,000 61.480 Balance Sheets Assets (computations explained in following paragraph) $400,000 $511,480 Equity Common stock Retained earnings 350,000 50,000 $400,000 61,480 $511.480 Total liabilities and equity

Explanation / Answer

Answer to questiona

Forecasted financial statements(Forecast 3)

Therefore by treating it as a loan @ 11.62% interest the income would be

particulars Amt($)

Revenue 160000

less:Operating expenses (77000)

income before interest and taxes 83000

less:Interest @11.62% (11620)

(100000*11.62%)

income before taxes 71380

less:tax@30% (21414)

(71380*30%)

net income 49966

Answer to question b

tax advantage of debt financing

Forecast2 Forecast3

Beginning retained earnings 15000 15000

add:net income 58100 49966

less:div (58100*20%) (11620) -

ending retained earnings 61480 64966

the tax advantage due to debt financing is to the extent of (24900-21414) = 3486 $

Answer to questionc

if the transaction is classified as debt the retained earnings closing is 64966$ which is higher than compared to 61480$ if it is classified as equity.and in case of debt watson would get 11.62% fixed interest and in case of equity he would get dividend to the extent of 20%

Based on the facts of the case the company is potentially doing well generating higher returns so it is advisable to make it an equity investment though the company would get a tax advantage it is less when it is compared to the return on the investment and wealth maximity in future.

Answer to questiond

As part of good governance, companies will seek to minimise their tax liability through "tax planning", making the most of the tools and mechanisms which the government makes available to them specifically for this purpose: allowances, deductions, rebates, exemptions, and so on. Tax planning is tax compliant behaviour but there is a grey area between this and "tax avoidance".

Tax avoidance, while legitimate, can be seen as aggressive when it involves using financial instruments and arrangements not intended as, or anticipated by, governments as a vehicle for tax advantage. For example, the use of overseas tax havens. Avoiding tax and bending the rules of the tax system is not illegal unlike tax evasion; it is operating within the letter, but perhaps not the spirit, of the law.

So it is advisable not to enter into such agreements as it is unethical.

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