Early in January, 2010, Tellco acquired a new machine and incurred $100,000 of i

Question

Early in January, 2010, Tellco 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 10 years using the straight-line method.

1.) Calculate the ROI for Tellco for 2010.
2.) Calculate the ROI for Tellco for 2010, assuming the 100,000 had been capitalized and depreciated over 10 years using the straight-line method.
3.) Given answers to A and B, why would a company want to account for this expenditure as a expense?
4.) Assuming that the $100,000 is capitalized, what will be the effect on the ROI for 2011 and subsequent years, compared to expensing the interest, installation and overhead costs in 2011. Explain.

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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