In the debt-financed factory purchase scenario, what is the Net Income change in the first year after tax?

In the debt-financed factory purchase scenario, what is the Net Income change in the first year after tax?

• A. Net income increases by $12.
• B. Net income decreases by $12.
• C. Net income decreases by $20.
• D. Net income increases by $20.

Answer: (B)

Debt financing creates an annual interest expense that lowers pretax income, and the tax system provides a shield on that interest. Depreciation from the new factory also reduces taxable income, generating its own tax shield. In the first year, if the project doesn’t add any operating income beyond the asset’s depreciation, the net income change comes from the balance of these two effects. A convenient way to think about it is that the after‑tax cost of the debt is the interest cost multiplied by (1 minus the tax rate), while the depreciation provides a tax shield equal to depreciation times the tax rate. When the after‑tax cost of the debt outweighs the depreciation tax shield, net income falls. In this scenario, those numbers align so that the after‑tax impact is a drop of 12 dollars in net income in the first year.

Debt financing creates an annual interest expense that lowers pretax income, and the tax system provides a shield on that interest. Depreciation from the new factory also reduces taxable income, generating its own tax shield. In the first year, if the project doesn’t add any operating income beyond the asset’s depreciation, the net income change comes from the balance of these two effects. A convenient way to think about it is that the after‑tax cost of the debt is the interest cost multiplied by (1 minus the tax rate), while the depreciation provides a tax shield equal to depreciation times the tax rate. When the after‑tax cost of the debt outweighs the depreciation tax shield, net income falls. In this scenario, those numbers align so that the after‑tax impact is a drop of 12 dollars in net income in the first year.