Last year, Stewart-Stern Inc. reported $11,250 of sales, $4,500 of operating cos

Question

Last year, Stewart-Stern Inc. reported $11,250 of sales, $4,500 of operating costs other than depreciation, and $1,250 of depreciation. The company had $3,500 of bonds outstanding that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%. During last year, the firm had expenditures on fixed assets and net operating working capital that totaled $2,000. These expenditures were necessary for it to sustain operations and generate future sales and cash flows. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $1,600. By how much will the depreciation change cause (1) the firm's net income and (2) its free cash flow to change? Note that the company uses the same depreciation for tax and stockholder reporting purposes.

Explanation / Answer

(1) the firm's net income

Last Years firm's net income = (Sales - Operating cost - Depreciation - Interest Expenses)*(1-tax rate)

Last Years firm's net income = (11250-4500-1250-3500*6.5%)*(1-35%)

Last Years firm's net income = $ 3427.125

This Years firm's net income = (Sales - Operating cost - Depreciation - Interest Expenses)*(1-tax rate)

This Years firm's net income =  (11250-4500-(1250+1600)-3500*6.5%)*(1-35%)

This Years firm's net income = $ 2387.125

Changes in Net Income = This Years firm's net income - Last Years firm's net income

Changes in Net Income = 2387.125-3427.125

Changes in Net Income = - $ 1040

and (2) its free cash flow to change?

Last Years free cash flow = Last Years firm's net income + Post Tax Interest Expenses + Depreciation - Increase in fixed assets and net operating working capital

Last Years free cash flow = 3427.125 + 3500*6.5%*(1-35%) + 1250 - 2000

Last Years free cash flow = 2825

This Years free cash flow = This Years firm's net income + Post Tax Interest Expenses + Depreciation - Increase in fixed assets and net operating working capital

This Years free cash flow = 2387.125 + 3500*6.5%*(1-35%) + (1250+1600) - 2000

This Years free cash flow = 3385

its free cash flow to change = This Years free cash flow - Last Years free cash flow

its free cash flow to change = 3385-2825

its free cash flow to change = $ 560

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