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 25.00%.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 $1,250.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.

Question

Quizplus · Accepted Answer

(1) The increase in depreciation will reduce the firm's taxable income by $1,250, which will decrease the tax liability by $312.50 ($1,250 x 0.25). Thus, the net income will increase by $937.50 ($1,250 - $312.50).
(2) Free cash flow is calculated as FCF = NOPAT + Depreciation - Capital Expenditures - ΔNWC. Since there is no change in sales, operating costs, interest expense, tax rate, or capital expenditures, the only change is the increase in depreciation by $1,250. Therefore, the free cash flow will increase by $312.50 ($1,250 - $937.50).

Last Year,Stewart-Stern Inc