Last year, Stewart-Stern Inc. reported $11,250 of sales, $4,500 of operating costs other than depreciation, and...

Last year, Stewart-Stern Inc. reported $11,250 of sales, $4,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had $3,500 of bonds outstanding that carry a 6.50% interest rate, and its federal-plus-state income tax rate was 35.00%. During last year, the firm had expenditures on fixed assets and net operating working capital that totaled $2,000. These expenditures were necessary for it to sustain operations and generate future sales and cash flows. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $1,225. By how much will the depreciation change cause (1) the firm's net income and (2) its free cash flow to change? Note that the company uses the same depreciation for tax and stockholder reporting purposes. Do not round the intermediate calculations.

Expert Solution

A. Calculation of Free Cash Flows Last Year

	Particulars	Amount
	Sales	$ 11,250
Less -	Operating Costs	$ (4,500)
Less -	Depreciation	$ (1,250)
Less -	Interest Cost	$ (228)
	Profit Before Tax	$ 5,273
Less -	Tax at 35%	$ (1,845)
	Profit After Tax	$ 3,427
Less -	Capital Expenditure on Fixed Assets and Net Operating Working Capital	$ (2,000)
Add -	Non-Cash Item - Depreciation	$ 1,250
	Free Cash Flow	$ 2,677

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B. Calculation of Free Cash Flows This Year

	Particulars	Amount
	Sales	$ 11,250
Less -	Operating Costs	$ (4,500)
Less -	Depreciation	$ (2,475)
Less -	Interest Cost	$ (228)
	Profit Before Tax	$ 4,048
Less -	Tax at 35%	$ (1,417)
	Profit After Tax	$ 2,631
Add -	Non-Cash Item - Depreciation	$ 2,475
	Free Cash Flow	$ 5,106

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1. Change in Net Income = (Net Income this year - Net Income last year)*100/Net Income last year

= (2631 - 3427) * 100 / 3427

= -23.23%

Net Income has declined by 23.23%.

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2. Change in Free Cash Flow = (Free Cash Flow this year - Free Cash Flow last year)*100/Free Cash Flow last year

= (5106 - 2677) * 100 / 2677

= 90.74%

Free Cash Flow has increased by 90.74%.

jeff jeffy answered 10 months ago

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