Question

Nokela Industries purchases a $ 37.6 million​ cyclo-converter. The​ cyclo-converter will be depreciated by $ 9.4 million per year over four​ years, starting this year. Suppose​ Nokela's tax rate is 40 %. a. What impact will the cost of the purchase have on earnings for each of the next four​ years? b. What impact will the cost of the purchase have on the​ firm's cash flow for the next four​ years?

Answer 1

1) The cyclo converter which is purchased will be shown as fixed asset under balance sheet.

The cyclo converter will then be depreciated for four years which is its useful life. The depreciation will be charged to income statement

Depreciation being expense the earnings of the company would decline due to depreciation.

The company would receive tax shield due to the depreciation expense

Therefore, the after tax deduction of earnings for next four years would be $9.40 million*(1-0.40) = $5.64 million

The earnings of the company would reduce by $5.64 million each of the four years.

5.64

2)

Depreciation is a non cash expense and therefore it will not have any impact of the cash flow but due to depreciation expense the company

will have tax savings which will reduce the cash outflow of the company for the next four years. The purchase of cyclo converter will result in cash outflow from investing activity in the first year

Therefore impact on cash flow for the first year would be (-37.6+9.4-5.64) -$33.84 million

The cash flow impact for the following three years would be saving of tax and therefore cash flow would be (9.4-5.64) = $3.76 million