Can someone help me with this M&I 400 question?
This question is in the accounting section; I will write down the question with the context and give the answer that M&I gave, as well as list what I don't understand about it. For the record, this is question #14 in the Basic Accounting Questions section. I give some additional context that was stated on an earlier problem.
Question: "Apple has bought $100 worth of factories with debt. Assume the factories depreciated at a rate of 10% per year until Year 3. At the start of Year 3, all the factories break down and the value of the equipment is $0. The loan must be paid back now. Walk me through the three statements."
Answer in the book: "After 2 years, the value of the factories is $80 with depreciation. On the income statement, $80 is on the pre-tax income line. With a 40% tax rate, Net Income declines by $48. On the cash flow statement, Net Income is down $48, but the non-cash expense is added back in under the Cash Flow from Operations section. Under the Cash Flow from Financing section, the loan is paid back so it is down $100. Overall, the Net Change in Cash is down $68. On the Balance Sheet, Cash is down $68, PP&E is down by $100, and Shareholders' Equity by $48, so both sides balance."
A few things here that I do not understand.
1. If the factory is depreciating at a rate of 10% per year, then why is the value after 2 years $80? Wouldn't it be $90 after the first year and $81 after the second year (aka 10% of that year's value rather than 20% of the starting value)?
2. Where did they get $68 from as the Net Change in Cash the Cash Flow Statement? Net Income is down by $48 and the $20 of depreciation is added back in so we have $68. Then we subtract the loan paid back so shouldn't our Net Change in Cash be ($168)? Instead of just $68?
Thanks in advance, any help would be greatly appreciated.
1.) In straight-line depreciation the building depreciates at a fixed rate of 10% of the ORIGINAL asset cost every year, so deprecation is 10% or $10 every year for 10 years until the value of the asset is 0.
2.) For cash flow, in cash from operations net income is down by $48, but there is no deprecation add back because you are writing down the building, but you do add back the write down of $80, so cash from operations is up $32. But you also have to pay back the entire loan, meaning cash from financing will be down $100, and the total change in cash is down $68.
Thanks!
1. Depreciation, like loan amortization, is based on the original value. So "10% depreciation per year" means 10% of the starting value, i.e. $10 per year, not 10% of the net value at the beginning of the year
2. Net income is -48, but you add back the non-cash 80 writeoff so you're at +32. You then pay the $100 loan off, so your net cash flow is -68
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