CFA Practice Question

There are 520 practice questions for this study session.

CFA Practice Question

A company is considering making material adaptations to its warehouse and equipment. The cost will be $25,000,000, with a benefit period of 10 years. The income tax rate during this period will be 30%. The company is considering the effects of capitalizing the cost versus expensing the cost. Which of the following statements would be true?

I. If the cost is capitalized, cash flows in years 2-10 will be higher by $750,000.
II. If the cost is expensed, cash flows in years 2-10 will be higher by $750,000.
III. If cost is capitalized, there will be a smoother pattern of income over the life of the project.
A. I, II and III
B. II and III
C. I and III
Explanation: In the second year and the years following, there are no associated expenses if the cost is expensed in the first year. If the cost is capitalized, there are depreciation expenses of $2,500,000, which will improve cash flow by decreasing the taxes by $750,000 = ($2,500,000 x .3). If the cost is capitalized, the expense in each of years 1-10 will be the same -the depreciation expense of $2,500,000.

User Contributed Comments 12

User Comment
kalps Good question. The CASH FLOW impact looks at the tax ONLY. i.e. cash flow will be higher in 2-10 due to the tax benefit of the depreciation = 0.3*25,000,000/10
shasha by simplifying:- expensed NI = GP*(1-t); taking it as the expensed CFO. capitalized NI = (GP-depreciation)*(1-t) = GP*(1-t)-depreciation*(1-t) so, CFO from capitalized = NI + depriation = GP*(1-t) + depreciation*t say: capitalized CFO is more than expensed CFO with the amount of "depreciation *t".
Iceblue Does this mean "Depreciation is tax deductible like interest expense"?
danlan Depreciation is related to net income, but not cash flow.
Intereste expense is related to both operational cash flow and net income, not EBIT.
zhinan here CF means CFO? the total CF is not influenced by capital or expense
AusPhD zhinan, they save on their tax bill in years 2-10 through reporting lower income, these tax savings are real cash flows
surjoy Shasha Brilliant stuff....I like this..
cfahitman can someone explain why from the notes it says total CF is the same for capital and operating lease, but AusPhD says the tax saving is from real CF.... im a bit confused.
enum AusPhD is wrong. Financial accounting and tax accounting is different. The choice of capitalization does not affect your taxes payable - it affects your financial numbers only.
boddunah very good question
gaurav1207 CASH FLOWS....Thats the word to look for in this question!
teje from a cash flow perspective, the $25,000,000 cost was an outflow in CFI in the year incurred. By capitalizing this cost, we are just trying to smooth out earnings on the income statement...so instead of taking a massive hit in one year, we spread this cost over several years. The cash flows in subsequent periods will be higher as the depreciation expense does create a tax shield and since depreciation expense is non-cash, we add this back to CFO.

enum is correct, only affects your financial numbers, i.e. not real cash flows
You need to log in first to add your comment.