Question

Companies X and Z have the same beginning-of-the-year book value of equity and the same tax rate. The companies have identical transactions throughout the year and report all transactions similarly except for one. Both companies acquire a £300,000 printer with a three- year useful life and a salvage value of £0 on January 1 of the new year. Company X capitalizes the printer and depreciates it on a straight-line basis, and Company Z expenses the printer. The following year-end information is gathered for Company X. Company X As of December 31 £10,000,000 Ending shareholders' equity Tax rate Dividends 25% £0.00 Net income £750,000 Based on the information given, Company Z's return on equity using year-end equity will be closest to:

Answer 1

Company Z's return on equity for the year, after expensing a £300,000 printer, is 5.25%.

Step-by-step explanation:

To calculate Company Z's return on equity (ROE), we first need to determine Company Z's net income. Because Company Z expenses the printer immediately, unlike Company X which capitalizes it, this will reduce Company Z's net income in the year of purchase by £300,000. Tax savings from expensing the printer are £300,000 × 25% tax rate = £75,000. So the net effect on income for expensing the printer will be £300,000 - £75,000 = £225,000.

Company X reported net income of £750,000; had it expensed the printer, its net income would have been reduced by £225,000. Therefore, Company Z's adjusted net income would be £750,000 - £225,000 = £525,000. The starting book value of equity was the same for both companies, and neither paid dividends, so Company X's ending equity of £10,000,000 is also the starting equity for Company Z. Company Z's ROE is then £525,000 / £10,000,000 = 5.25%.

Answer 2

Company Z's return on equity using year-end equity will be 100%.

Step-by-step explanation:

Company Z expenses the printer, which means it deducts the full cost of the printer (£300,000) in the year it was purchased. This will reduce the net income for the year compared to Company X, which only depreciates the printer over its useful life. To calculate Company Z's return on equity using year-end equity, we need to determine the net income for the year. Since Company Z expenses the printer, its net income will be lower than Company X. However, the book value of equity at the end of the year will remain the same for both companies, as the printer was expensed rather than depreciated.

Using the information provided, we can calculate Company Z's net income by subtracting the dividends and the change in equity from the beginning equity. The change in equity will be £0, as the printer was expensed. So, the net income for Company Z will be £10,000,000 - £0 - £0 = £10,000,000.

Now, we can calculate the return on equity for Company Z using the net income and the beginning equity. The return on equity formula is: Return on Equity = (Net Income / Beginning Equity) x 100%

Plugging in the values, we get: Return on Equity = (£10,000,000 / £10,000,000) x 100% = 100%

So, Company Z's return on equity using year-end equity will be 100%.