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. These costs will be $25,000,000 and will have 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 costs using straight-line depreciation versus expensing the costs. Assuming the costs are expensed, in the first year, ______

I. cash flows will be higher by $6,750,000 than if the costs were capitalized.

II. debt-to-equity ratios will be higher.

III. debt-to-assets ratios will be higher.
Correct Answer: I, II and III

Expenses relating to the costs of the adaptation would be $25,000,000 in the first year if the costs are expensed, whereas they would be $2,500,000 ($25,000,000/10) in the first year if the costs are capitalized. The expensing would cause $22,500,000 ($25,000,000 - $2,500,000) more in expenses. This would cause a difference in taxes paid of $6,750,000 ($22,500,000 x 0.3). The expensing would cause lower taxes. The debt-to-equity ratio would be higher under expensing, because the income is lower, making the equity lower. The assets will be lower, causing the debt-to-assets ratio to be higher.

User Contributed Comments 10

User Comment
evica but not overall CFs, only operating CF will be higher...
tony1973 No evica. The overall CFs remain the same for the entire period when the asset is used, but the question asks what happens in the first year.
dlo1 Net Cash flow (excluding taxes) does not change whether costs are capitalized or expensed. However, the decision will affect income and hence the income taxes paid (a cashflow) in the first year.
todolist good Q
quanttrader the expense is non-cash related, therefore only concern is taxes for cash flow analysis. Expense for expense is 25 mill, cap (via sd) = 25 mill /10 = 2.5 mill. Diff = 25 -2.5 = 22.5 (another way to look at it is reported income under cap will be 22.5 mill higher than expense and therefore under cap, pay 22.5 mill * tax rate = 6.75 million add'l taxes. also income and therefore equity will be less if expensed and hence, debt/equity is higher. Assets will of course be less (since under cap-- expense is taken on as asset) and therefore debt/asset will be higher under expense.
investoprenuer Why cost $22.5m in First year and not $25m if expensed? What's the point of deducting the $2.5m if fully expensed?
moneyguy investoprenuer -- It doesn't state the cost is 22.5m in the first year. It says the difference in taxes paid between expensing/capitalization is (22.5m * .3). Straight line depreciation would result in this much more taxes being paid in the first year as Net Income would be higher by this amount.
philjoe Just so everyone knows, the financial reporting books =/= tax reporting books. The difference in depreciation recognized under GAAP and tax reporting creates DTA and DTL.
domedome "The depreciation method used for tax reporting ( MACRS ) is independent from the one chosen by management for financial reporting. It is tax payable not tax expense that determine the cash outlie for tax payment. Therefore ,the choice of depreciation method has no impact on the statement of cash flow." Why answer I is correct?
Sagarsan88 In The LOS study, they mentioned CFO is higher if you capitalise and lower if you expense. then in this case how is the CFO higher if you exepense it. Can someone pls explain?
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