CapEx of $100 with straight-line depreciation over 10 years and a 20% tax rate affects Year 0 and Year 1. Which description is correct for Year 1?

• A. Net income decreases by $8; cash from operations increases by $2
• B. Net income increases by $8; cash from operations decreases by $2
• C. Net income decreases by $10; cash from operations increases by $12
• D. Net income unchanged; cash from operations unchanged

Answer: (A)

Depreciation creates a tax shield and is a non-cash expense, so it affects both net income and cash flow differently. With a CapEx of 100 spread over 10 years, depreciation is 10 per year. The tax rate is 20%, so the tax shield from that depreciation is 2.

For Year 1, pretax income falls by 10 due to the depreciation expense, taxes drop by 2, and net income declines by 8 (-10 + 2). Cash from operations, however, includes adding back the non-cash depreciation (10), so the change in cash from operations is -8 + 10 = +2. Therefore, Year 1 shows net income decreasing by 8 and cash from operations increasing by 2.