A $100 write-down of debt has what effect on the income statement and cash flow, assuming a 40% tax rate?

A $100 write-down of debt has what effect on the income statement and cash flow, assuming a 40% tax rate?

• A. Pre-Tax Income increases by $100; Net Income increases by $60; Cash Flow from Operations decreases by $40; Net Change in Cash decreases by $40; Balance Sheet shows Cash -$40, Debt -$100, and Equity +$60.
• B. Pre-Tax Income increases by $100; Net Income increases by $60; Cash Flow from Operations increases by $60; Net Change in Cash increases by $60; Balance Sheet shows Cash +$60, Debt -$100, and Equity +$60.
• C. Pre-Tax Income decreases by $100; Net Income decreases by $60; Cash Flow from Operations decreases by $60; Net Change in Cash decreases by $60; Balance Sheet shows Cash -$60, Debt -$100, and Equity -$60.
• D. Pre-Tax Income increases by $100; Net Income increases by $60; Cash Flow from Operations increases by $40; Net Change in Cash increases by $40; Balance Sheet shows Cash +$40, Debt -$100, and Equity +$60.

Answer: (C)

A debt write-down by 100 is recorded as a charge that reduces liabilities and hits the income statement. That 100 lowers pretax income. With a 40% tax rate, the tax shield on this item means net income falls by 100 × (1 − 0.40) = 60. In the cash flow picture described, this translates to a reduction in cash flow from operations by 60 and a net decrease in cash by 60. On the balance sheet, the debt decreases by 100, while equity falls by 60 due to the reduced retained earnings from the lower net income, and cash falls by 60.

A debt write-down by 100 is recorded as a charge that reduces liabilities and hits the income statement. That 100 lowers pretax income. With a 40% tax rate, the tax shield on this item means net income falls by 100 × (1 − 0.40) = 60. In the cash flow picture described, this translates to a reduction in cash flow from operations by 60 and a net decrease in cash by 60. On the balance sheet, the debt decreases by 100, while equity falls by 60 due to the reduced retained earnings from the lower net income, and cash falls by 60.