The 2013 income statement and other information for Mallard Corporation, which is about to purchase a new machine at a cost of $500 and a new computer system at a cost of $300, follows.
Sales ......... $1,000
Cost of goods sold .... 600
Gross profit ....... 400
Operating expenses .... 150
Income before tax ..... 250
Income taxes ....... 85
Net income ....... $ 165
• The two new assets are expected to generate a 25% annual rate of growth in the firm’s sales.
• The firm will include the machine’s depreciation expense as part of cost of goods sold and the depreciation expense on the computer system as part of operating expenses.
• Excluding the new machine’s depreciation, the firm’s cost of goods sold is expected to increase at an annual rate of 7.5%.
• Excluding the new computer system’s depreciation, the firm’s operating expenses are expected to increase at an annual rate of 4.0%.
• The firm’s gross total assets (net of asset retirements) are expected to increase at a rate of 20% per year. Average gross total assets in 2013 were $1,000. Assume that asset retirements generate no gains or losses.
• Both the machine and the computer system have a three-year useful life and a zero salvage value.
• Assume an income tax rate of 34%.
1. Assume that the assets are purchased on January 1, 2014. Prepare pro forma income statements for 2014 through 2016. Assume the firm elects to use the straight-line depreciation method for depreciating the new assets.
2. Repeat requirement 1 assuming instead that the firm elects to use the sum-of-the-years’ digits method for depreciating the new assets.
3. For both requirements 1 and 2, calculate the firm’s gross profit rate (gross profit divided by sales), NOPAT margin (net operating profit after tax divided by sales), and return on assets (NOPAT divided by average total assets). How does the use of the different depreciation methods affect the behavior of the ratios over the 2014–2016 period?