Which of the following correctly describes the Year 3 balance sheet effects after the write-down and loan payoff?

Which of the following correctly describes the Year 3 balance sheet effects after the write-down and loan payoff?

• A. Cash is up by $68; PP&E is up by $80.
• B. Cash is down by $68; PP&E down by $80; Debt down by $100; Equity down by $48.
• C. Cash is up by $40; Assets up by $60.
• D. Cash is unchanged; PP&E unchanged; Liabilities unchanged.

Answer: (B)

This question tests how a non-cash asset write-down and a loan payoff show up on the Year 3 balance sheet, including the tax effect of the write-down. First, writing down PP&E by 80 reduces the asset value by 80. It also creates a pretax loss of 80, which lowers taxes owed. With a 40% tax rate, the tax expense drops by 32, so the after-tax hit to equity from this write-down is 80 minus the 32 tax savings, i.e., 48. Put simply, PP&E falls by 80 and equity falls by 48 due to the reduced retained earnings. Second, paying off the loan reduces cash by 100 and reduces debt by 100. But the write-down’s tax shield boosts cash by 32, so the net cash change is -100 plus +32, which equals -68. So the year-end effects are cash down 68, PP&E down 80, debt down 100, and equity down 48. This keeps the balance sheet balanced since assets fall by 148 (80 + 68) while liabilities and equity fall by 100 and 48 respectively (100 + 48 = 148).

This question tests how a non-cash asset write-down and a loan payoff show up on the Year 3 balance sheet, including the tax effect of the write-down.

First, writing down PP&E by 80 reduces the asset value by 80. It also creates a pretax loss of 80, which lowers taxes owed. With a 40% tax rate, the tax expense drops by 32, so the after-tax hit to equity from this write-down is 80 minus the 32 tax savings, i.e., 48. Put simply, PP&E falls by 80 and equity falls by 48 due to the reduced retained earnings.

Second, paying off the loan reduces cash by 100 and reduces debt by 100. But the write-down’s tax shield boosts cash by 32, so the net cash change is -100 plus +32, which equals -68.

So the year-end effects are cash down 68, PP&E down 80, debt down 100, and equity down 48. This keeps the balance sheet balanced since assets fall by 148 (80 + 68) while liabilities and equity fall by 100 and 48 respectively (100 + 48 = 148).