In Year 2, following depreciation of 10 and an additional $10 of interest expense, with a 40% tax rate, how does Net Income change relative to the start of Year 2?

In Year 2, following depreciation of 10 and an additional $10 of interest expense, with a 40% tax rate, how does Net Income change relative to the start of Year 2?

• A. Net Income decreases by $12
• B. Net Income decreases by $20
• C. Net Income decreases by $6
• D. Net Income increases by $12

Answer: (A)

The after-tax impact of expenses on net income is the pre-tax decrease times (1 minus the tax rate). Here, depreciation is 10 and interest expense is 10, for a total pretax decrease of 20. With a 40% tax rate, taxes drop by 0.40 × 20 = 8. Net income then changes by 20 − 8 = 12, i.e., it decreases by $12 relative to the start of Year 2. So the correct result is a $12 decrease in Net Income.

The after-tax impact of expenses on net income is the pre-tax decrease times (1 minus the tax rate). Here, depreciation is 10 and interest expense is 10, for a total pretax decrease of 20. With a 40% tax rate, taxes drop by 0.40 × 20 = 8. Net income then changes by 20 − 8 = 12, i.e., it decreases by $12 relative to the start of Year 2. So the correct result is a $12 decrease in Net Income.