Question

Last year, Stewart-Stern Inc. reported $11,250 of sales, $4,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had $3,500 of bonds outstanding that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%. During last year, the firm had expenditures on fixed assets and net working capital that totaled $2,000. These expenditures were necessary for it to sustain operations and generate future sales and cash flows. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $725. By how much will the depreciation change cause (1) the firm's net income and (2) its free cash flow to change?

Answer 1

Answer:

(1) Net income is reduced / decreased by $725

(2) Free cash flow is increased by $254

Explanation:

Before Change

Sales =                                                  11250

-operating cost =                                  4500

-Depreciation =                                     1250

Net income before interest and tax = 5500

-Interest Expense =                               228

Net income before tax =                      5272

-Tax 35% = 5272 x 35% =                    1845

Net income after interest and Tax =    3427

Free cash flow = CFO = Net Income before interest and Tax (1-Tax rate) + non-cash expenses – increase in non-cash net working capital.

CFO = 5500 (1-0.35) + 1250 – 2000 = 2825

After Change

New Depreciation = 1250 + 725 = 1975

Revise Net Income = 5500  + 1250 - 1975 = 4775

Effect on Net Income = 5500 - 4775 = Reduce /  decrease by $725

Revised Free cash flow = Revised CFO = 4775 (1-0.35) + 1975 - 2000

Revised CFO = 3079

Effect on Free cash flow = 3079 - 2825 = increased by $254