P r o f its v e r sus Cash Fl o w . Butterfly Tractors had $14 million in sales last year. Cost of

QUESTION

P r o f its v e r sus Cash Fl o w . Butterfly Tractors had $14 million in sales last year. Cost of goods sold was $8 million, depreciation expense was $2 million, interest payment on out- standing debt was $1 million, and the firms tax rate was 35 percent. a. What was the firms net income and net cash flow? b. What would happen to net income and cash flow if depreciation were increased by $1 million? How do you explain the differing impact of depreciation on income versus cash flow? c. Would you expect the change in income and cash flow to have a positive or negative im- pact on the firms stock price? d. Now consider the impact on net income and cash flow if the firms interest expense were $1 million higher. Why is this case different from part (b)?
a) Figures in $millions Sales 14 COGS 8 Dep Expense (Sales COGS) 2 EBIT (Sales-COGS-Dep expense) 4 Interest payment on debt 1 Earnings before tax (EBIT-interest payment) 3 Tax @ 35% (35%*Earnings before tax) 1.05 Net income (Earnings before tax tax) 1.95 Net cash flow (Net income + Depreciation) 3.95 b) Figures in millions Sales 14 COGS 8 Dep Expense (Sales COGS) 3 EBIT (Sales-COGS-Dep expense) 3 Interest payment on debt 1 Earnings before tax (EBIT-interest payment) 2 Tax @ 35% (35%*Earnings before tax) 0.7 Net income (Earnings before tax tax) 1.3 Net cash flow (Net income + Depreciation) 4.3 Net income decreases from $1.95 million to $1.3 million a decrease of $0.65 million Net cash flow increased from $3.95 million to $4.3 million an increase of $0.35 million c)Looking at the formulas for depreciation affects each, it is apparent that depreciation is subtracted from income (meaning: larger depreciation results in lower net income); and it adds more to net cash flow because of the larger amount. d)Positive

impact because investors tend to care more about cash flow. Stock price should increase because cash flow increases. e) Figures in millions Sales 14 COGS 8 Gross profit 6 Dep Expense (Sales COGS) 2 EBIT (Sales-COGS-Dep expense) 4 Interest payment on debt 2 Earnings before tax (EBIT-interest payment) 2 Tax @ 35% (35%*Earnings before tax) 0.7 Net income (Earnings before tax tax) 1.3 Going back to the original parameters of the problem and then adding in another $1M for interest ($1M + $1M = $2M). In this case, Net income decreased by $0.65M ($1.95M $1.3M) Net Cash Flow is equal to $1.3M + $2M = $3.3Mthis amount is $.65M less than the original answer ($3.95M = $3.3M).

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