Butterfly Tractors had $18 million in sales last year. Cost of goods sold was $9 million, depreciation expense was $3 million, interest payment on outstanding debt was $2million, and the firm’s tax rate was 30%.

Butterfly Tractors had $18 million in sales last year. Cost of goods sold was $9 million, depreciation expense was $3 million, interest payment on outstanding debt was $2million, and the firm’s tax rate was 30%.

a. What was the firm’s net income?
 

b. What was the firm’s cash flow? 


c. What would happen to net income and cash flow if depreciation were increased by $2 million?
 

d. Would you expect the change in income and cash flow to have a positive or negative impact on the firm’s stock price?

• Positive

  Correct
• Negative
• No change

e. What would be the impact on net income if depreciation was $2 million and interest expense was $3 million?

• Increase
• Decrease
• No change

  Correct

f. What would be the impact on cash if depreciation was $2 million and interest expense was $3 million?

• Increase
• Decrease

  Correct
• No change 

   

   

  Explanation

  a.
  

  	($ in millions)
  Sales		$	17.50
  Cost of goods sold			8.70
  Interest expense			1.70
  Depreciation expense			2.70
  Taxable income		$	4.40
  Taxes (30%)			1.32
  Net income		$	3.08

  
  b.
  Net cash flow = net income + depreciation expense = $5.78 million
  
  c.
  If depreciation expense were increased by $2 million, net income would be reduced by $1.19 million. Cash flow = (net income + depreciation) would be increased by − $1.19 million + $2 million = $.51 million.
  Cash flow increases because depreciation expense is not a cash outflow, but increasing the depreciation expense for tax purposes reduces taxes paid by $.51 million.
  
  d.
  The impact on stock price is likely to be positive. Cash available to the firm would increase. The reduction in net income would be recognized as resulting entirely from accounting changes, not as a consequence of any changes in the underlying profitability of the firm.
  
  e.
  The net income would not change. The taxable income would remain the same, as would net income.
  
  f.
  If interest expense was $2 million higher and the depreciation was $2 million lower, the taxes will be the same, but the drop in depreciation would cause a decrease in cash flow by $1 million.