Question 2.3: Suppose Global had an additional $1 million depreciation exp...
Suppose Global had an additional $1 million depreciation expense in 2016. If Global’s tax rate on pretax income is 26%, what would be the impact of this expense on Global’s earnings? How would it impact Global’s cash at the end of the year?
PLAN
Depreciation is an operating expense, so Global’s operating income, EBIT, and pretax income would be affected. With a tax rate of 26%, Global’s tax bill will decrease by 26 cents for every dollar that pretax income is reduced. In order to determine how Global’s cash would be impacted, we have to determine the effect of the additional depreciation on cash flows. Recall that depreciation is not an actual cash outflow, even though it is treated as an expense, so the only effect on cash flow is through the reduction in taxes.
EXECUTE
Global’s operating income, EBIT, and pretax income would fall by $1 million because of the $1 million in additional operating expense due to depreciation.
This $1 million decrease in pretax income would reduce Global’s tax bill by 26% × $1 million = $0.26 million. Therefore, net income would fall by $1 – $0.26 = $0.74 million.
On the statement of cash flows, net income would fall by $0.74 million, but we would add back the additional depreciation of $1 million because it is not a cash expense. Thus, cash from operating activities would rise by -$0.74 + 1 = $0.26 million. Therefore, Global’s cash balance at the end of the year would increase by $0.26 million, the amount of the tax savings that resulted from the additional depreciation deduction.
EVALUATE
The increase in cash balance comes completely from the reduction in taxes. Because Global pays $0.26 million less in taxes even though its cash expenses have not increased, it has $0.26 million more in cash at the end of the year.