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. $$\Delta \text { Net Income } \quad \Delta \text { Free Cash Flow }$$
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Question

Quizplus · Accepted Answer

The increase in depreciation by $1,225 will decrease the taxable income, thus affecting both net income and free cash flow. 1. **Net Income Change ($\Delta$ Net Income):**    - Depreciation increases by $1,225, reducing taxable income by the same amount.    - The tax savings from the increased depreciation is $1,225 * 35% = $428.75.   - Therefore, the net income decreases by the increase in depreciation minus the tax savings: $1,225 - $428.75 = $796.25 decrease in net income.2. **Free Cash Flow Change ($\Delta$ Free Cash Flow):**    - Free cash flow is increased by the depreciation increase because, while it reduces net income, it does not involve a cash outlay.   - The decrease in net income is $796.25 (as calculated above), but the actual cash flow is not reduced by the full amount of the depreciation increase because of the tax savings.    - The increase in depreciation ($1,225) does not reduce cash flow since it's a non-cash charge, and we add back the tax savings on the increased depreciation ($428.75) to find the change in free cash flow.   - Therefore, the change in free cash flow is the increase in depreciation itself, which is $1,225, plus the tax savings from the depreciation, which is already accounted for in the net income calculation. However, since the question asks for the change due to depreciation, we consider the depreciation's direct effect on free cash flow, which is positive because it's a non-cash expense that reduces taxable income. The net effect on free cash flow is the tax savings, which is $428.75, making the overall change in free cash flow positive.The correct answer is A, with a decrease in net income by $796.25 and an increase in free cash flow by $428.75.

Last Year,Stewart-Stern Inc Δ Net Income Δ Free Cash Flow \Delta \text { Net Income } \quad \Delta \text { Free Cash Flow }Δ Net Income Δ Free Cash Flow

Last Year,Stewart-Stern Inc $\Delta \text { Net Income } \quad \Delta \text { Free Cash Flow }$