Question

Company Z is making an investment in a new plant and equipment. They had originally expected to depreciate the assets over a 10-year basis, but then found that they could depreciate over 7 years instead (thereby increasing the amount depreciated each year). If Company Z depreciates over 7 years, which of the following would occur?

	a.	The firm's operating income (EBIT) would increase.
	b.	The firm's taxable income would increase.
	c.	The firm's reported net income would increase.
	d.	The firm's tax payments would increase.
	e.	The higher depreciation expense would create a tax shield for the corporation.

Answer 1

A)EBIT is Earnings before Interest and Taxes.(FALSE)

Sales Revenue	XXX
Expenses(Depreciation,amortisation,Salaries,rent,Cost of good sold without tax and interest etc)	(XXX)
EBIT	XXX

Hence if company depreciates over 7 years instead of 0, then company's EBIT would reduce as the amount depreciated increases and is spread over 7 years instead of 10 decreasing the Operating profit of the firm.

B)Taxable income would increase.(FALSE)

The depreciation expenses reduces the earnings on which taxes are to be paid.

Sales revenue	XXX
Expenses(includes depreciation)	XXX
EBIT	XXX
Interest	XXX
EBT	XXX
Taxes	XXX

Depreciation is finally an expense hence that much amount of expense reduces the earnings.Hence depreciation reduces the taxable income.The larger is the depreciation expense, lower is the taxable income.

D) The firm's tax payments would increase.(FALSE)

The company's Depreciation expense reduces the taxable income and hence reduces the company's tax payments. Depreciation reduces the profit , hence the amount of tax which is paid on that profit also reduces for the firm if it dint had depreciation in its book of accounts.

C) net income would increase.(FALSE)

Depreciation has impact on the net income of the business. Depreciation Expense lowers the company's net income-its profit. As it is the non cash flow expense, it doesnt change the company's cash flow.

E) Higher depreciation increases the tax shield.(TRUE)

tax shield is the amount of benefit we get by paying depreciation expense.

=tax rate * Depreciation expense.