Early in January 2010, Tellco, Inc. acquired a new machine and incurred $100,000

Question

Early in January 2010, Tellco, Inc. acquired a new machine and incurred $100,000 of interest, installation , and overhead costs that should have been capitalized but were expensed. The company earned net operating income of $1,000,000 on average total assets of $8,000,000 for 2010. Assume that the total cost of the new machine will be depreciated over 10years using the straight-line method.

A. Calculate the ROI for Tellco, Inc for 2010
b. Calculate the ROI for Tellco, Inc for 2010 assuming that the $100,000 had been capitalized and depreciated over 10 years using the straight-line method.
c. Given your answers to a and b, why would the company want to account for the expediture as an expense?
d. Assuming that the $100,000 is capitalized, what will be the effect on ROI for 2011 and subsequent years, compared to expensing the interest, installation, and overhead costs in 2010? Explain your answer.

Explanation / Answer

ANSWER

ROI = Net Income/Total Assets
(a) ROI = 1,000,000/8,000,000 = 12.5%
(b). If $100,000 had been capitalised, Total Assets would increase to 8100,000
Addl Depn on Asset = $100,000/10yrs = $10,000
SO Net Op Income will increase by $100,000 which was wrongly expensed = $1,100,000
Net Op Income will reduce by Amt of Dep = $1100,000-$10,000 = $1090,000
so ROI = 1090,000/8100,000 = 13.46%
(c) COmpany would like to expense the amount as it will reduce Net Op income. This will result in less Tax being paid.
(d) If $100,000 is capialised, the annual depn will result in redusing the tax liability over a period of 10 yrs (useful life of asset). If it is expensed, company will get the beenfit of expense only in that year but no benefit in later years.

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