After one year, with depreciation 10% and 10% interest, and a 40% tax rate, which of the following statements is true?

After one year, with depreciation 10% and 10% interest, and a 40% tax rate, which of the following statements is true?

• A. Cash Flow from Operations increases by $2.
• B. PP&E decreases by $10.
• C. Pre-Tax Income increases by $20.
• D. Net Income decreases by $12.

Answer: (D)

The effect hinges on how depreciation and interest affect after‑tax earnings. If both are 10, the total drop in pretax income is 20. With a 40% tax rate, taxes fall by 0.40 × 20 = 8 as a tax shield. Net income changes by the pretax drop minus the tax saving: -20 - (-8) = -12. So net income decreases by 12. This captures the overall bottom‑line impact after tax. The pretax income would not increase (it would fall by 20), and while PP&E would indeed be lower by the depreciation amount, the statement that best reflects the given scenario’s financial effect on profitability is the net income decrease of 12.

The effect hinges on how depreciation and interest affect after‑tax earnings. If both are 10, the total drop in pretax income is 20. With a 40% tax rate, taxes fall by 0.40 × 20 = 8 as a tax shield. Net income changes by the pretax drop minus the tax saving: -20 - (-8) = -12. So net income decreases by 12.

This captures the overall bottom‑line impact after tax. The pretax income would not increase (it would fall by 20), and while PP&E would indeed be lower by the depreciation amount, the statement that best reflects the given scenario’s financial effect on profitability is the net income decrease of 12.