Walk me through what happens across the income statement, cash flow statement, and balance sheet if a company spends $100 and chooses to either expense it immediately or capitalize it and depreciate it over 5 years, with a 25% tax rate and everything else held constant.

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Accepted Answer

Walk me through what happens across the income statement, cash flow statement, and balance sheet if a company spends $100 and chooses to either expense it immediately or capitalize it and depreciate it over 5 years, with a 25% tax rate and everything else held constant.

1. Task Overview
Task: compute the Year 1 impact on EBITDA, EBIT, Net Income, and cash for both the expense and the capitalize treatment, and explain why the two approaches diverge even though the same $100 is spent.

Step 1: Given Data — The Transaction
A company spends $100 in cash and has to decide whether to expense the cost immediately or capitalize it as an asset.

Line ItemValue
  
    Cash spent$100
    Tax rate25% (0.25)
    Useful life if capitalized5 years
    Depreciation methodStraight-line

Step 2: EBITDA Impact Under Each Treatment
Start with the metric that sits above D&A, since this is where the two treatments first diverge.

Show EBITDA Impact Formula
  EBITDA Impact = -Cost (if expensed); EBITDA Impact = $0 (if capitalized, since the cost never becomes an operating expense)

Using this formula, compute the Year 1 EBITDA impact under both treatments.

Step 3: EBIT Impact Under Each Treatment
Next, layer in depreciation to move from EBITDA to EBIT.

Show EBIT Formula
  EBIT Impact = EBITDA Impact - Depreciation, where Depreciation = Cost / Useful Life (capitalized case only)

Using this formula, compute the Year 1 EBIT impact under both treatments.

Step 4: Net Income Impact Under Each Treatment
Apply the tax shield to move from EBIT to Net Income.

Show Net Income Formula
  Net Income Impact = EBIT Impact × (1 - Tax Rate)

Using this formula, compute the Year 1 Net Income impact under both treatments.

Step 5: Cash Flow and Balance Sheet Impact

Show Cash Flow Formula
  Total Cash Impact = -Cost + (Depreciation × Tax Rate) [capitalized]; Total Cash Impact = -Cost + (Cost × Tax Rate) [expensed]

Assume:

Tax rate = 25% (0.25)
  Useful life = 5 years
  Straight-line depreciation, no salvage value
  Entire $100 paid in cash in Year 1, no financing involved

Using these inputs, compute the Year 1 CFO, CFI, and net Balance Sheet impact under each treatment.

3-Statement Change: Capitalize vs. Expense $100

📋 What you're given

1. Task Overview

Step 1: Given Data — The Transaction

Step 2: EBITDA Impact Under Each Treatment

Step 3: EBIT Impact Under Each Treatment

Step 4: Net Income Impact Under Each Treatment

Step 5: Cash Flow and Balance Sheet Impact

💡 Model answer

Step 1: EBITDA Impact

Step 2: EBIT Impact

Step 3: Net Income Impact

Step 4: Cash Flow and Balance Sheet Impact

Final Results

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Line Item	Value
Cash spent	$100
Tax rate	25% (0.25)
Useful life if capitalized	5 years
Depreciation method	Straight-line