Depreciation increasing by $10, with a 40% tax rate, what happens to Net Income?

Depreciation increasing by $10, with a 40% tax rate, what happens to Net Income?

• A. Net Income decreases by $6
• B. Net Income decreases by $10
• C. Net Income decreases by $4
• D. Net Income remains unchanged

Answer: (A)

Depreciation lowers pretax income and also provides a tax shield. When depreciation increases by 10, pretax income falls by 10. Taxes then drop by 40% of that amount, which is 4. So the net income change is the drop in pretax income minus the tax savings: -10 + 4 = -6. In other words, net income decreases by 6 dollars. This isn’t unchanged, because taxes fall but earnings still decline; it isn’t a full 10 because part of the impact is offset by the tax shield (4); and it isn’t only 4 because that would ignore the reduced pretax income.

Depreciation lowers pretax income and also provides a tax shield. When depreciation increases by 10, pretax income falls by 10. Taxes then drop by 40% of that amount, which is 4. So the net income change is the drop in pretax income minus the tax savings: -10 + 4 = -6. In other words, net income decreases by 6 dollars. This isn’t unchanged, because taxes fall but earnings still decline; it isn’t a full 10 because part of the impact is offset by the tax shield (4); and it isn’t only 4 because that would ignore the reduced pretax income.