Question

The 2015 I/S and other information for CZK Inc., which is about to purchase a new machine at a cost of $450 and a new computer system at a cost of $330, appears next:

Sales	$1,000
COGS	700
Gross profit	300
Operating expenses	100
Income b/ taxes	200
Income taxes	50
Net income	$150

Additional information:

-Two new assets are expected to generate a 20% annual rate of growth in the firm’s sales.

-The firm will include the depreciation expense on the machine as part of COGS and the depreciation expense on the computer system as part of operating expenses.

-Excluding the depreciation on the new machine, the firm’s COGS is expected to increase at an annual rate of 5%.

-Excluding the depreciation on the new computer system, the firm’s operating expenses are expected to increase at an annual rate of 8%.

-Average total assets in 2015 were $900. Expected average total assets in 2016, 2017, & 2018 are $1,150, $1,250, & $1,370, respectively.

-Both machine and computer system have a three-year useful life and a zero salvage value.

-Assume an income tax rate of 25%.

Required:

a. Assume that the assets are purchased on January 1, 2016. Prepare pro forma income statements for 2016 through 2018 with the straight-line depreciation method for the new assets.

b. Repeat requirement a, assuming instead that the firm elects to use the sum-of-the-years’ digits method.

c. For both requirements 1 & 2, calculate the firm’s gross profit rate (gross profit divided by sales), NOPAT margin (net operating profit after tax divided by sales), and return on assets (NOPAT divided by total assets). How does the use of the different depreciation methods affect the behavior of the ratios over the period? Which method would management choose to maximize their personal wealth?

Answer 1