Answer:
A. Net income is $825,000; and Net cash flow is $1,225,000.
B. Net income is $750,000; and Net cash flow is $1,150,000.
C. Parts A net cash flow will equal part B net cash flow by deducting $75,000 difference, or Parts B net cash flow will equal part A net cash flow by addiing $75,000 difference.
Explanation:
The following are given:
Operating income (EBIT) before depreciation expense = $1,500,000
Depreciation expense = $400,000
Tax rate = 25%
We therefore proceed as follows:
A. If the company is 100% equity financed (zero debt), calculate its net income and net cash flow.
<u>Calculation of net income</u>
Income after depreciation but before tax = Operating income (EBIT) before depreciation expense - Depreciation expense = $1,500,000 - $400,000 = $1,100,000
Tax expense = Income after depreciation but before tax * Tax rate = $1,100,000 * 25% = $275,000
Net income = Income after depreciation but before tax - Tax expenses = $1,100,000 - $275,000 = $825,000
<u>Calculation of net cash flow</u>
Net cash flow = Net income + Depreciation expense = $825,000 - $400,000 = $1,225,000
B. If the company (instead) has $100,000 in annual interest expense, recalculate the net income and net cash flow.
<u>Calculation of net income</u>
Income after depreciation and interest expenses but before tax = Operating income (EBIT) before depreciation expense - Depreciation expense - Interest expense = $1,500,000 - $400,000 - $100,000 = $1,000,000
Tax expense = Income after depreciation and interest expense but before tax * Tax rate = $1,000,000 * 25% = $250,000
Net income = Income after depreciation and interest expense but before tax - Tax expenses = $1,000,000 - $250,000 = $750,000
<u>Calculation of net cash flow</u>
Net cash flow = Net income + Depreciation expenses = $750,000 + $400,000 = $1,150,000
C. Explain the difference in your answers to parts A & B – specifically, reconcile the change in net cash flow that occurred.
Difference in net income = Part A net income - Part B net income = $825,000 - $750,000 = $75,000
Difference in net cash flow = Part A net cash flow - Part B net cash flow = $1,225,000 - $1,150,000 = $75,000
Each of Part A net income and net cash flow is $75,000 greater than part B because part A is an 100% equity financed with the need to pay annual interest expense on debt of $100,000 like in Part B before calculating the Tax expense and the net income.
The $75,000 diffence is as a result of additional tax that Part A has to paid on $100,000. That is,
Additional tax expense in part A = Interest expense not paid in Part A * Tax rate = $100,000 * 25% = $25,000
Diffrenrence = Intererest expense not paid in part A - Additional tax expense = $100,000 - $25,000 = $75,000
For example, if there is no annual interest of $100,000 to be paid in part B, we can then reconcile by just addinf back the difference as follows:
Part B new net cash flow = Part B initial cash flow + Difference in net cash flow = $1,150,000 + $75,000 = $1,225,000 = Part A net cash flow
Also, if annual interest expense has to be paid in part A as a result of being now financed by debt, we will just deduct the difference as follows:
Part A new net cash flow = Part A initial cash flow - Difference in net cash flow = $1,225,000 - $75,000 = $1,150,000 = Part B initial net cash flow.
