Quick question on ROA and capital expenditure

Ernest_Seow · January 28, 2014, 6:34am

Dear all,

I understand from Schweser Notes that :

If an expenditure has been capitalized instead of expensed, ROA will increase.

ROA= [(Net Income)+Interest(1-tax)]/ Total Assets

Question 1: How will ROA increase when in fact Total Assets (denominator) increase? Or is it because the change in Net Income (numerator) is more significant than the increase in Total Assets?

Question 2: I think it might be quite senseless to think in this way but I will like to ask: For a capital expenditure, when we perform the double entries it will be something like i) reduce cash (current assets) and ii) increase fixed assets account by the same amount ( non-current assets). The effect should be net right? Why is there an effect in the 1st place.

Thanks for reviewing and explaining.

Cheers,

Ernest

S2000magician · January 28, 2014, 6:56am

Yes, we generally assume that assets > net income (because net income is less than accumulated net income, and accumulated net income is less than equity, and equity is less than assets). Thus, an increase of the same amount in net income and in assets will be a bigger percentage of net income than of assets.

When you capitalize interest (instead of expensing it) you don’t change the cash payment of the interest. The only thing you change is the amount of tax paid. You:

Increase long-term assets by int
Decrease expenses by int
Increase taxable income by int
Increase taxes paid by int × t
Increase net income by int × (1 – t)
Increase equity by int × (1 – t)
Decrease cash by int × t
Increase total assets by int – (int × t) = int × (1 – t)

Ernest_Seow · January 28, 2014, 7:07am

S2000magician:

Ernest_Seow:

Dear all,

I understand from Schweser Notes that :

If an expenditure has been capitalized instead of expensed, ROA will increase.

ROA= [(Net Income)+Interest(1-tax)]/ Total Assets

Question 1: How will ROA increase when in fact Total Assets (denominator) increase? Or is it because the change in Net Income (numerator) is more significant than the increase in Total Assets?

Yes, we generally assume that assets > net income (because net income is less than accumulated net income, and accumulated net income is less than equity, and equity is less than assets). Thus, an increase of the same amount in net income and in assets will be a bigger percentage of net income than of assets.

Ernest_Seow:

Question 2: I think it might be quite senseless to think in this way but I will like to ask: For a capital expenditure, when we perform the double entries it will be something like i) reduce cash (current assets) and ii) increase fixed assets account by the same amount (non-current assets). The effect should be net right? Why is there an effect in the 1st place.

When you capitalize interest (instead of expensing it) you don’t change the cash payment of the interest. The only thing you change is the amount of tax paid. You:

Increase long-term assets by int

Decrease expenses by int

Increase taxable income by int

Increase taxes paid by int × t

Increase net income by int × (1 – t)

Increase equity by int × (1 – t)

Decrease cash by int × t

Increase total assets by int – (int × t) = int × (1 – t)

Thanks for taking the time off to address my doubts, S2000magician. I understand for question 1 but for question 2 however, I’m a little lost… In a nutshell are you saying that though the below 2 transactions occur (double entry):

Cash decreases (current asset account)
Fixed assets increase (non-current asset account

Assumably that cash has been used to purchase the fixed assets

The change in amount for each account is different. Is that what you are trying to say?

On a side note, the interest and tax implication will be touched on further in topic- income tax right? I’m currently on reading #30- long lived assets

Thanks again, appreciate your help S2000magician.