Question

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1. Sports Company limited built and equipped a $4,800,000 plant and brought into operations early in...

1. Sports Company limited built and equipped a $4,800,000 plant and brought into operations early in year 1. Earnings of the company (before depreciation and income taxes) is estimated at $2,200,000 in year 1, $ 2,500,000, in year 2, $2,700,000 in year 3, $3,500,000 in year 4, $ 3,900,000 in year 5, and $ 4,000,000 in year 6. The company can use straight line method, double declining balance method, or sum of the years’ digits depreciation method for the new plant. Assume the plants’ useful life is 9 years (salvage value $ 300,000) and Income tax rate of 45%.
Compute the separate effect that each of these three methods of depreciation would have on

A. Depreciation (all three methods)
B. Income taxes
C. Net Income
D. Cash Flow (assumed equal to net income before depreciation) (all the four in sheet1)
2. Show the graph for A, B, C, and D. (One graph for depreciation, Income tax, etc.) in sheet 2
3. Comment on Items A to D in sheet 3Sports Company limited built and equipped a $4,800,000 plant and brought

Solutions

Expert Solution

A. Depreciation for all three methods is presented below:

i) Staight line method

Year Depreciable base Dep factor Dep exp
1 $45,00,000 11.11% $5,00,000
2 $45,00,000 11.11% $5,00,000
3 $45,00,000 11.11% $5,00,000
4 $45,00,000 11.11% $5,00,000
5 $45,00,000 11.11% $5,00,000
6 $45,00,000 11.11% $5,00,000

ii) Double declining balance method

Depreciation rate = straight line dep rate * 2

= 11.11%*2 = 22.22%

Year Book value Depreciation Ending book value
1 $48,00,000.0 $10,66,666.7 $37,33,333.3
2 $37,33,333.3 $8,29,629.6 $29,03,703.7
3 $29,03,703.7 $6,45,267.5 $22,58,436.2
4 $22,58,436.2 $5,01,874.7 $17,56,561.5
5 $17,56,561.5 $3,90,347.0 $13,66,214.5
6 $13,66,214.5 $3,03,603.2 $10,62,611.3

iii) Sum of year digits method

Sum of year digits = 9(9+1) / 2 = 45

Depreciation = depreciable base * remaining useful life / sum of year digit

Year Depreciable base Dep factor Dep exp
1 $45,00,000 0.20 $9,00,000
2 $45,00,000 0.18 $8,00,000
3 $45,00,000 0.16 $7,00,000
4 $45,00,000 0.13 $6,00,000
5 $45,00,000 0.11 $5,00,000
6 $45,00,000 0.09 $4,00,000

B) Income taxes

As a result of depreciation, the income taxes to be paid would be reduced to the extent of depreciation.

i) Straight line method

Year Depreication Reduction in taxes
1 $5,00,000 $2,25,000
2 $5,00,000 $2,25,000
3 $5,00,000 $2,25,000
4 $5,00,000 $2,25,000
5 $5,00,000 $2,25,000
6 $5,00,000 $2,25,000

ii) Double declining method

Year Depreication Reduction in taxes
1 $10,66,666.7 $4,80,000.0
2 $8,29,629.6 $3,73,333.3
3 $6,45,267.5 $2,90,370.4
4 $5,01,874.7 $2,25,843.6
5 $3,90,347.0 $1,75,656.1
6 $3,03,603.2 $1,36,621.4

iii) Sum of year digits

Year Depreication Reduction in taxes
1 $9,00,000 $4,05,000
2 $8,00,000 $3,60,000
3 $7,00,000 $3,15,000
4 $6,00,000 $2,70,000
5 $5,00,000 $2,25,000
6 $4,00,000 $1,80,000

C) The net income would reduce as a result of depreciation. The net income under the three methods is:

i) Straight line method

EBIT $22,00,000 $25,00,000 $27,00,000 $35,00,000 $39,00,000 $40,00,000
Depreciation $5,00,000 $5,00,000 $5,00,000 $5,00,000 $5,00,000 $5,00,000
EBT $17,00,000 $20,00,000 $22,00,000 $30,00,000 $34,00,000 $35,00,000
Income tax $7,65,000 $9,00,000 $9,90,000 $13,50,000 $15,30,000 $15,75,000
Net income after tax $9,35,000 $11,00,000 $12,10,000 $16,50,000 $18,70,000 $19,25,000

ii) Double declining method

1 2 3 4 5 6
EBIT $22,00,000 $25,00,000 $27,00,000 $35,00,000 $39,00,000 $40,00,000
Depreciation $10,66,667 $8,29,630 $6,45,267 $5,01,875 $3,90,347 $3,03,603
EBT $11,33,333 $16,70,370 $20,54,733 $29,98,125 $35,09,653 $36,96,397
Income tax $5,10,000 $7,51,667 $9,24,630 $13,49,156 $15,79,344 $16,63,379
Net income after tax $6,23,333 $9,18,704 $11,30,103 $16,48,969 $19,30,309 $20,33,018

iii) Sum of year digits

1 2 3 4 5 6
EBIT $22,00,000 $25,00,000 $27,00,000 $35,00,000 $39,00,000 $40,00,000
Depreciation $9,00,000 $8,00,000 $7,00,000 $6,00,000 $5,00,000 $4,00,000
EBT $13,00,000 $17,00,000 $20,00,000 $29,00,000 $34,00,000 $36,00,000
Income tax $5,85,000 $7,65,000 $9,00,000 $13,05,000 $15,30,000 $16,20,000
Net income after tax $7,15,000 $9,35,000 $11,00,000 $15,95,000 $18,70,000 $19,80,000

D) Cash flow will increase as a result of depreciation

1 2 3 4 5 6
EBIT $22,00,000 $25,00,000 $27,00,000 $35,00,000 $39,00,000 $40,00,000
Depreciation $5,00,000 $5,00,000 $5,00,000 $5,00,000 $5,00,000 $5,00,000
EBT $17,00,000 $20,00,000 $22,00,000 $30,00,000 $34,00,000 $35,00,000
Income tax $7,65,000 $9,00,000 $9,90,000 $13,50,000 $15,30,000 $15,75,000
Net income after tax $9,35,000 $11,00,000 $12,10,000 $16,50,000 $18,70,000 $19,25,000
Net cash flow $14,35,000 $16,00,000 $17,10,000 $21,50,000 $23,70,000 $24,25,000

ii) Double declining method

1 2 3 4 5 6
EBIT $22,00,000 $25,00,000 $27,00,000 $35,00,000 $39,00,000 $40,00,000
Depreciation $10,66,667 $8,29,630 $6,45,267 $5,01,875 $3,90,347 $3,03,603
EBT $11,33,333 $16,70,370 $20,54,733 $29,98,125 $35,09,653 $36,96,397
Income tax $5,10,000 $7,51,667 $9,24,630 $13,49,156 $15,79,344 $16,63,379
Net income after tax $6,23,333 $9,18,704 $11,30,103 $16,48,969 $19,30,309 $20,33,018
Net cash flow $16,90,000 $17,48,333 $17,75,370 $21,50,844 $23,20,656 $23,36,621

iii) Sum of year digits

1 2 3 4 5 6
EBIT $22,00,000 $25,00,000 $27,00,000 $35,00,000 $39,00,000 $40,00,000
Depreciation $9,00,000 $8,00,000 $7,00,000 $6,00,000 $5,00,000 $4,00,000
EBT $13,00,000 $17,00,000 $20,00,000 $29,00,000 $34,00,000 $36,00,000
Income tax $5,85,000 $7,65,000 $9,00,000 $13,05,000 $15,30,000 $16,20,000
Net income after tax $7,15,000 $9,35,000 $11,00,000 $15,95,000 $18,70,000 $19,80,000
Net cash flow $16,15,000 $17,35,000 $18,00,000 $21,95,000 $23,70,000 $23,80,000

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