91Ó°ÊÓ

The Menendez Corporation expects to have sales of 12 million dollar in 2002 . costs other than depreciation are expected to be 75 percent of sales, and depreciation is expected to be1.5 million dollar. All sales revenues will be collected in cash, and costs other than depreciation must be paid for during the year. Menendez's federal-plus-state tax rate is 40 percent. a. Set up an income statement. What is Menendez's expected net cash flow? b. Suppose Congress changed the tax laws so that Menendez's depreciation expenses doubled. No changes in operations occurred. What would happen to reported profit and to net cash flow? c. Now suppose that Congress, instead of doubling Menendez's depreciation, reduced it by 50 percent. How would profit and net cash flow be affected? d. If this were your company, would you prefer Congress to cause your depreciation expense to be doubled or halved? Why? e. In the situation in which depreciation doubled, would this possibly have an adverse effect on the company's stock price and on its ability to borrow money?

Step by step solution

01

Calculate Total Revenue

The total revenue for Menendez Corporation is given as $12 million. Since this will be collected in cash, we simply note the sales revenue as $12 million.

02

Calculate Costs Other Than Depreciation

Costs other than depreciation are 75 percent of sales. Calculate this as follows:\[\text{Costs other than depreciation} = 0.75 \times 12,000,000 = 9,000,000\]

03

Calculate Earnings Before Tax (EBT)

Subtract costs and depreciation from the total revenue to find the Earnings Before Tax (EBT):\[\text{EBT} = 12,000,000 - 9,000,000 - 1,500,000 = 1,500,000\]

04

Calculate Tax

Calculate the tax amount using the federal-plus-state tax rate of 40%:\[\text{Tax} = 0.40 \times 1,500,000 = 600,000\]

05

Calculate Net Income

Determine the net income by subtracting the tax from the EBT:\[\text{Net Income} = 1,500,000 - 600,000 = 900,000\]

06

Calculate Net Cash Flow

Net cash flow includes net income plus depreciation (as depreciation is a non-cash charge):\[\text{Net Cash Flow} = 900,000 + 1,500,000 = 2,400,000\]

07

Effect of Doubling Depreciation on Profit and Cash Flow

If depreciation doubles, it becomes \(3 million. Recalculate EBT:\[\text{EBT (New)} = 12,000,000 - 9,000,000 - 3,000,000 = 0\]Tax would be zero since EBT is zero. Thus, Net Income becomes \)0, but Net Cash Flow increases to:\[\text{Net Cash Flow (New)} = 0 + 3,000,000 = 3,000,000\]

08

Effect of Reducing Depreciation by 50% on Profit and Cash Flow

If depreciation is reduced by 50%, it becomes $0.75 million. Recalculate EBT:\[\text{EBT (New)} = 12,000,000 - 9,000,000 - 750,000 = 2,250,000\]Tax is recalculated as:\[\text{Tax (New)} = 0.40 \times 2,250,000 = 900,000\]Net Income becomes:\[\text{Net Income (New)} = 2,250,000 - 900,000 = 1,350,000\]Net Cash Flow then is:\[\text{Net Cash Flow (New)} = 1,350,000 + 750,000 = 2,100,000\]

09

Preference on Depreciation Changes

Doubling depreciation results in higher cash flow ($3,000,000), though net income is zero. Halving depreciation increases net income ($1,350,000) but results in lower cash flow ($2,100,000). The preference between higher cash flow or net income depends on the company's priority for cash reserves or profitability measures.

10

Potential Adverse Effects of Doubling Depreciation

Doubling depreciation can lower reported earnings to zero, which might impact the company's stock price negatively due to perceptions of lower profitability. However, it improves cash flow, potentially aiding in operations without adversely affecting its ability to borrow if lenders focus on cash flows.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Income Statement

An income statement is crucial in financial management as it provides a detailed overview of a company's financial performance over a specific period. It begins with revenue, followed by the deduction of expenses, ultimately arriving at the net income. In the case of Menendez Corporation, the income statement starts with the total sales revenue of $12 million. From this, we subtract costs other than depreciation which amount to 75% of sales, resulting in $9 million.
Next, we deduct the depreciation, initially set at $1.5 million, to arrive at the Earnings Before Tax (EBT). Understanding this calculation allows companies to make informed decisions based on their actual financial position before taxes. Further down the line, taxes are calculated and subtracted to determine the net income, which reflects the actual profit the company makes after all expenses, including taxes, have been accounted for.

Depreciation Impact

Depreciation is a non-cash expense that impacts both the income statement and net cash flow. It's the systematic allocation of the cost of a tangible asset over its useful life. For Menendez Corporation, depreciation starts at $1.5 million. Increasing or decreasing depreciation affects two main financial metrics: reported profit and cash flow.

• If depreciation doubles to $3 million, the Earnings Before Tax (EBT) drops to zero, resulting in zero net income due to increased non-cash expenses. However, this doesn't affect cash flow negatively; in fact, net cash flow rises to $3 million as depreciation is added back to net income.
• Conversely, if depreciation is halved to $0.75 million, this improves reported profits to $1,350,000, although the net cash flow reduces to $2,100,000 because less depreciation is added back.

In summary, while depreciation affects reported earnings, it doesn't directly outflow cash, hence its impact on cash remains neutral or positive.

Net Cash Flow

Net Cash Flow is a vital metric in financial management, representing the key indicator of a company's financial health. It refers to the actual increase in cash reserves from operations, often calculated by adding back non-cash charges like depreciation to net income.
In Menendez's scenario, the initial net cash flow is $2.4 million. This includes the $900,000 net income and $1.5 million from depreciation. When depreciation is doubled, the net cash flow increases to $3 million, even though the net income becomes zero. On the other hand, when depreciation is halved, net cash flow decreases to $2.1 million.
This metric is crucial for maintaining liquidity, paying debts, and financing growth, and thus, companies often prioritize optimizing cash flow over net income for sustainable operations.

Tax Implications

Taxes are a significant factor in financial management as they directly impact net income. The tax rate affects both the company's profitability and its cash flow strategy. Menendez Corporation faces a 40% federal-plus-state tax rate.

• When the depreciation doubles, the taxable income is null, hence there's no tax payment, and while net income is zero, net cash flow benefits from the higher depreciation.
• If depreciation is cut by 50%, the taxable income increases, leading to higher taxes of $900,000, eating into net income and reducing net cash flow.

Understanding how operating decisions like depreciation affect tax payments allows companies to strategize better, balancing tax liabilities with profitability and cash flow needs. It's essential for companies to manage tax efficiently to optimize both their reported earnings and available cash.