Suppose a firm’s tax rate is 25%. a. What effect would a $10 million operating expense...

Suppose a firm’s tax rate is 25%.

a. What effect would a $10 million operating expense have on this year’s earnings? What effect would it have on next year’s earnings?

b. What effect would a $10 million capital expense have on this year’s earnings if the capital is depreciated at a rate of $2 million per year for five years? What effect would it have on next year’s earnings?

Expert Solution

a i) A $10 million operating expense would be immediately expensed in income statement, This will lead to reduction in taxes of ($10 million * 25%) = $2.5 million. Thus earnings would decline by $10 million operating exps ( - ) $2.5 million tax savings = $7.5 million net.

This year's earnings will decline by $7.5million

a ii) The Operating exps this year will have no effect on next year's earnings.

b i) Capital Exps do not impact earnings directly. These exps are not allowed as entire deduction in one year but as partly deduction in every year in the form of depreciation. Thus depreciation of $2 million would appear each as an operating expense. This will also lead to reduction in taxes of ($2million *25%) = $0.5 million.

The earnings would decline by $2million - $0.5 million = $1.5 million for each of the next 5 years. Thus this year's earnings will reduced by $1.5million

b ii) Next year's earnings will also decline by $1.5 million

jeff jeffy answered 1 year ago

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