Question
In: Finance
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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