In Year 2, the company records 10% depreciation on the factory assets and 10% interest expense. With a 40% tax rate, which statement best describes the impact on net income and cash flow from operations?

In Year 2, the company records 10% depreciation on the factory assets and 10% interest expense. With a 40% tax rate, which statement best describes the impact on net income and cash flow from operations?

• A. Operating income falls by 10 due to depreciation; Interest expense falls by 10; Net income rises; CFO rises by 12.
• B. Operating income falls by 20; Net income falls by 12; CFO from operations falls by 2; Total cash flow falls by 2.
• C. Operating income rises by 20; Net income increases by 12; CFO from operations increases by 8.
• D. No impact on any statement.

Answer: (B)

Depreciation is a non‑cash expense, so it lowers reported operating income but doesn’t use cash in the period. It also creates a tax shield: 40% of the depreciation amount reduces taxes. Here, depreciation of 10 lowers operating income by 10, and the tax saving is 0.4 × 10 = 4. Net income is thus down by 10 − 4 = 6 from depreciation. Interest expense reduces pretax income by 10. Taxes fall by 0.4 × 10 = 4, so net income drops by 10 − 4 = 6 from the interest expense. Total impact on net income from both items is 6 + 6 = 12, so net income falls by 12. For cash flow from operations, non‑cash depreciation is added back to net income, while interest is typically treated as a financing activity and not included in CFO. So CFO changes by net income change plus back the depreciation: −12 + 10 = −2. That means CFO from operations falls by 2. With that framework, the overall description matches: operating income declines by 20 (10 from depreciation and 10 from the interest‑related operating charge), net income falls by 12, CFO from operations falls by 2, and total cash flow falls by 2.

Depreciation is a non‑cash expense, so it lowers reported operating income but doesn’t use cash in the period. It also creates a tax shield: 40% of the depreciation amount reduces taxes. Here, depreciation of 10 lowers operating income by 10, and the tax saving is 0.4 × 10 = 4. Net income is thus down by 10 − 4 = 6 from depreciation.

Interest expense reduces pretax income by 10. Taxes fall by 0.4 × 10 = 4, so net income drops by 10 − 4 = 6 from the interest expense.

Total impact on net income from both items is 6 + 6 = 12, so net income falls by 12.

For cash flow from operations, non‑cash depreciation is added back to net income, while interest is typically treated as a financing activity and not included in CFO. So CFO changes by net income change plus back the depreciation: −12 + 10 = −2. That means CFO from operations falls by 2.

With that framework, the overall description matches: operating income declines by 20 (10 from depreciation and 10 from the interest‑related operating charge), net income falls by 12, CFO from operations falls by 2, and total cash flow falls by 2.