C10-1 Calculating Interest and Depreciation Expenses and Effects on Loan Covenan
ID: 2568795 • Letter: C
Question
C10-1 Calculating Interest and Depreciation Expenses and Effects on Loan Covenant Ratio Zoom Car Corporation (ZCC) plans to purchase approximately 100 vehicles on December 31. 2015, for $2.3 million, plus 10 percent total sales tax. ZCC expects to use the vehicles for 5 years and then sel for approximately $460,000. ZCC anticipates the following average vehicle use over each year ended December 31: 2016 15,000 2017 20,000 2018 14,500 2019 14,500 2020 5,000 Miles per year To finance the purchase, ZcC signed a 5-year promissory note on December 31, 2015, for $2.07 million, with interest paid annually at the market interest rate of 6 percent. The note carries loan covenants that require ZCC to maintain a minimum times interest earned ratio of 3.0 and a minimum fixed asset turnover ratio of 1.0. ZCC forecasts that the company will generate the following sales and preliminary earnings (prior to recording depreciation on the vehicles and interest on the note). (For purposes of this question, ignore income tax.) 2020 S 2,300 S 2,800 S 3,100 S 3.200 S 3,300 1,150 1,350 1,550 1.650 1,750 2016 2017 2018 2019 (in 000s) Sales Revenue Income before Depreciation and interest Expense Required: 1. Calculate the amount of interest expense that would be recorded each year. Interest Expense per year 2. Calculate the depreciation expense that would be recorded each year, using the following depreciation methods (a) Straight-line Straight-line Depre per yearExplanation / Answer
Answer 1 Interest expense = $2.07 million * 6% = $1,24,200 Answer 2-a Straight line depreciation per year = (Cost of vehicles - salvage value)/useful life Straight line depreciation = ($25,30,000 - $4,60,000) / 5 years = $4,14,000 Answer 2-b Double declining balance method Depreciation rate = 2 * Straight line depreciation rate * Beginning book value of vehicles Straight line depreciation rate = Straight line depreciation / Depreciable value of vehicle = $414000 / $2070000 = 20% Year Depreiation rate (2*20%) Beginning Book Value Depreciation expense 2016 40% $2,530,000 $1,012,000 2017 40% $1,518,000 $607,200 2018 40% $910,800 $364,320 2019 40% $546,480 $218,592 2020 40% $327,888 $131,155 Answer 2-c Units of production Depreciation per mile = (Cost - salvage value)/Total miles during useful life Depreciation per mile = $20,70,000 / 69000 miles = $30 per mile Year Depreciation per mile Miles running Depreciation Expense 2016 $30.00 15000 $450,000 2017 $30.00 20000 $600,000 2018 $30.00 14500 $435,000 2019 $30.00 14500 $435,000 2020 $30.00 5000 $150,000 Answer 3-a Times Interest earned ratio = Income before interest and taxes / Interest Expense Fixed Asset turnover ratio = Sales Revenue / Average fixed assets Net Income = Income before depreciation and interest - Depreciation - Interest Net Income 2016 2017 2018 2019 2020 Income before depreciation and Interest $1,150,000 $1,350,000 $1,550,000 $1,650,000 $1,750,000 Less : Depreciation $414,000 $414,000 $414,000 $414,000 $414,000 Less : Interest $124,200 $124,200 $124,200 $124,200 $124,200 Net Income $611,800 $811,800 $1,011,800 $1,111,800 $1,211,800 Times Interest Earned Ratio 2016 2017 2018 2019 2020 Income before depreciation and Interest $1,150,000 $1,350,000 $1,550,000 $1,650,000 $1,750,000 Less : Depreciation $414,000 $414,000 $414,000 $414,000 $414,000 Income before interest and taxes $736,000 $936,000 $1,136,000 $1,236,000 $1,336,000 Interest $124,200 $124,200 $124,200 $124,200 $124,200 Times Interest Earned Ratio 5.93 7.54 9.15 9.95 10.76 Fixed asset turnover ratio 2016 2017 2018 2019 2020 Sales Revenue $2,300,000 $2,800,000 $3,100,000 $3,200,000 $3,300,000 Average Fixed assets $2,323,000 $1,909,000 $1,495,000 $1,081,000 $667,000 Fixed asset turnover ratio 0.99 1.47 2.07 2.96 4.95
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