Question

Zoom Car Corporation (ZCC) plans to purchase approximately 100 vehicles on December 31, 2015, for $1.2 million, plus 10 percent total sales tax. ZCC expects to use the vehicles for 5 years and then sell them for approximately $240,000. ZCC anticipates the following average vehicle use over each year ended December 31:

	2016	2017	2018	2019	2020
Miles per year	10,000	15,000	4,250	4,250	2,500

To finance the purchase, ZCC signed a 5-year promissory note on December 31, 2015, for $1.08 million, with interest paid annually at the market interest rate of 6 percent. The note carries loan covenants that require ZCC to maintain a minimum times interest earned ratio of 3.0 and a minimum fixed asset turnover ratio of 1.0. ZCC forecasts that the company will generate the following sales and preliminary earnings (prior to recording depreciation on the vehicles and interest on the note). (For purposes of this question, ignore income tax.)

(in 000s)	2016		2017		2018		2019		2020
Sales Revenue	$	1,200	$	1,700	$	2,000	$	2,100	$	2,200
Income before Depreciation and Interest Expense		600		800		1,000		1,100		1,200
1. Calculate the amount of interest expense that would be recorded each year.    Calculate the depreciation expense that would be recorded each year, using the following depreciation methods: (a) Straight-line depreciation per year: (b) Double-declining-balance (Do not round intermediate calculations.)   depreciation expense 2016 2017 2018 2019 2020 (c) Units-of-production same table as b) 3. Using your answers to requirements 1 and 2, determine net income and the two loan covenant ratios in each year, assuming the company chooses the following depreciation methods: net income 2016 2017 2018 2019 2020 times interest earned ratio fixed asset turnover ratio (a) Straight-line (Enter your answers for Net Income in thousands (i.e., 50,500 should be entered as 50.5). Round "Net Income" to 1 decimal place and "Ratio Values" to 2 decimal places.) (b) Double-declining-balance (Enter your answers for Net Income in thousands (i.e., 50,500 should be entered as 50.5). Round "Net Income" to 1 decimal place and "Ratio Values" to 2 decimal places.) (c) Units-of-production (Enter your answers for Net Income in thousands (i.e., 50,500 should be entered as 50.5). Round "Net Income" to 1 decimal place and "Ratio Values" to 2 decimal places.) 4. Using your answers to requirement 3, indicate whether the loan covenants would be violated under the following depreciation methods: straight line, double declining balance, and units of production

Answer 1

Answer 1
Interest expense (1080000*6%)			64,800
Answer 2 (a)			Straight-line depreciation
Cost of assets (1200000*1.10)			1,320,000
Salvage value			240,000
Depreciable cost			1,080,000
Divided: useful life in Years			5
Depreciation expense per year			216,000
Answer 2 (b)			Double-declining-balance
Depreciation rate under (1/5 year =20%) (20%*2=40%)			40%
Book value of machine does not less than salvage value
Year	Beginning balance	Depreciation @ 40%	Ending balance
1	1,320,000	528,000	792,000
2	792,000	316,800	475,200
3	475,200	190,080	285,120
4	285,120	45,120	240,000
5	240,000	-	240,000
Answer 2 (C)			Units-of-production
Cost of assets (1200000*1.10)	1320000
Salvage value	240000
Depreciable cost	1080000
Divided: useful life in miles Total of Miles	36,000
Depreciation expense per mile	30
Year	Miles	Depreciation expense per mile	Depreciation expense
1	10,000	30	300,000
2	15,000	30	450,000
3	4,250	30	127,500
4	4,250	30	127,500
5	2,500	30	75,000

Straight-line depreciation
Years	2016	2017	2018	2019	2020
Income before Depreciation and interest expense	600.0	800.0	1,000.0	1,100.0	1,200.0
Less: Depreciation expense	216.0	216.0	216.0	216.0	216.0
Income before interest expense	384.0	584.0	784.0	884.0	984.0
Less: Interest expense	64.8	64.8	64.8	64.8	64.8
Net income	319.2	519.2	719.2	819.2	919.2
Income before interest expense	384.0	584.0	784.0	884.0	984.0
Divided by: Interest expense	64.8	64.8	64.8	64.8	64.8
Times interest earned ratio	5.93	9.01	12.10	13.64	15.19
Beginning balance	1,320.0	1,104.0	888.0	672.0	456.0
Less: Depreciation expense (in 000)	216.0	216.0	216.0	216.0	216.0
Ending balance	1,104.0	888.0	672.0	456.0	240.0
Average Book value ((Beginning balance+ Ending balance)/2)	1,212.0	996.0	780.0	564.0	348.0
Sales revenue	1,200	1,700	2,000	2,100	2,200
Divided by: Average Book value of asset	1,212	996	780	564	348
Fixed asset Turnover ratio	0.99	1.71	2.56	3.72	6.32
Double-declining-balance
Years	2016	2017	2018	2019	2020
Income before Depreciation and interest expense	600.0	800.0	1,000.0	1,100.0	1,200.0
Less: Depreciation expense	528.0	316.8	190.1	45.1
Income before interest expense	72.0	483.2	809.9	1,054.9	1,200.0
Less: Interest expense	64.8	64.8	64.8	64.8	64.8
Net income	7.2	418.4	745.1	990.1	1,135.2
Income before interest expense	72.0	483.2	809.9	1,054.9	1,200.0
Divided by: Interest expense	64.8	64.8	64.8	64.8	64.8
Times interest earned ratio	1.11	7.46	12.50	16.28	18.52
Beginning balance	1,320.0	792.0	475.2	285.1	240.0
Less: Depreciation expense (in 000)	528.0	316.8	190.1	45.1	-
Ending balance	792.0	475.2	285.1	240.0	240.0
Average Book value ((Beginning balance+ Ending balance)/2)	1,056.0	633.6	380.2	262.6	240.0
Sales revenue	1,200	1,700	2,000	2,100	2,200
Divided by: Average Book value of asset	1,056	634	380	263	240
Fixed asset Turnover ratio	1.14	2.68	5.26	8.00	9.17
Units-of-production
Years	2016	2017	2018	2019	2020
Income before Depreciation and interest expense	600.0	800.0	1,000.0	1,100.0	1,200.0
Less: Depreciation expense	300.0	450.0	127.5	127.5	75.0
Income before interest expense	300.0	350.0	872.5	972.5	1,125.0
Less: Interest expense	64.8	64.8	64.8	64.8	64.8
Net income	235.2	285.2	807.7	907.7	1,060.2
Income before interest expense	300.0	350.0	872.5	972.5	1,125.0
Divided by: Interest expense	64.8	64.8	64.8	64.8	64.8
Times interest earned ratio	4.63	5.40	13.46	15.01	17.36
Beginning balance	1,320.0	1,020.0	570.0	442.5	315.0
Less: Depreciation expense (in 000)	300.0	450.0	127.5	127.5	75.0
Ending balance	1,020.0	570.0	442.5	315.0	240.0
Average Book value ((Beginning balance+ Ending balance)/2)	1,170.0	795.0	506.3	378.8	277.5
Sales revenue	1,200	1,700	2,000	2,100	2,200
Divided by: Average Book value of asset	1,170	795	506	379	278
Fixed asset Turnover ratio	1.03	2.14	3.95	5.54	7.93
Answer 4
Under straight line method, year 2016 Fixed assets turnover ratio is less than 1. Loan covenants would be violated.
Under Double-declining-balance, year 2016 Times interest earned ratio is below 3. Loan covenants would be violated.
Under Units-of-production, loan covenants would not be violated.