CFA 2 FRA - LOS 19.b - Kaplan question

Express Delivery Inc. (EDI) reported the following year-end data:

Depreciation expense $30 million Net income $30 million Total assets $535 million Shareholder’s equity $150 million Effective tax rate 35 percent

Last year EDI purchased a fleet of delivery vehicles for $140 million. For the first year, straight-line depreciation was used assuming a depreciable life of 7 years with no salvage value. However, at year-end EDI’s management determined that assumptions of a useful life of 5 years with a salvage value of 10 percent of the original value were more appropriate. How would the return on assets (ROA) and return on equity (ROE) for last year change due to the change in depreciation assumptions? ROA and ROE would be closest to:

Answer:

The reported ROA and ROE are 5.6% (30/535) and 20.0% (30/150) respectively. Under the new depreciation assumptions, depreciation expense would be (140-14)/5 = 25.2 million. Under the original assumptions depreciation of the fleet was 20 million. Therefore depreciation increases by 5.2 million. With the change in depreciation methods EDI would have reported:

Depreciation expense $35.20 million (30 + 5.2) Net income $26.62 million (30 − (5.2 × (1-0.35))) Total assets $529.80 million (535 − 5.2 ) Shareholder’s equity $146.62 million (150 − 3.38)

Note that assets would have been lower by $5.2 million due to the new depreciation assumptions and shareholder’s equity by $3.38 million (5.2 × (1 − 0.35)) due to lower retained earnings. Tax liabilities would have fallen by $1.82 million to balance the $5.2 million reduction in assets. Therefore, ROA would have been 5.0% (26.62 / 529.80) and ROE would have been 18.16% (26.62 / 146.62).

My question: In (140-14)/5 = 25.2 million

Where does 14 come from?

However, at year-end EDI’s management determined that assumptions of a useful life of 5 years with a salvage value of 10 percent of the original value were more appropriate