Question

C10-1 Calculating Interest and Depreciation Expenses and Effects on Loan Covenant Ratios (Chapters 9 and 10) [LO 9-3, LO 9-7, LO 10-2, LO 10-5]

Zoom Car Corporation (ZCC) plans to purchase approximately 100 vehicles on December 31, 2015, for $1.4 million, plus 10 percent total sales tax. ZCC expects to use the vehicles for 5 years and then sell them for approximately $280,000. ZCC anticipates the following average vehicle use over each year ended December 31:

	2016	2017	2018	2019	2020
Miles per year	10,000	15,000	7,250	7,250	2,500

   To finance the purchase, ZCC signed a 5-year promissory note on December 31, 2015, for $1.26 million, with interest paid annually at the market interest rate of 6 percent. The note carries loan covenants that require ZCC to maintain a minimum times interest earned ratio of 3.0 and a minimum fixed asset turnover ratio of 1.0. ZCC forecasts that the company will generate the following sales and preliminary earnings (prior to recording depreciation on the vehicles and interest on the note). (For purposes of this question, ignore income tax.)

(in 000s)	2016		2017		2018		2019		2020
Sales Revenue	$	1,400	$	1,900	$	2,200	$	2,300	$	2,400
Income before Depreciation and Interest Expense		700		900		1,100		1,200		1,300

Required:
1.	Calculate the amount of interest expense that would be recorded each year.

   

2.	Calculate the depreciation expense that would be recorded each year, using the following depreciation methods:

(a)	Straight-line

____________ per year

(b)	Double-declining-balance (Do not round intermediate calculations.)

Year Depreciation expense

2016 $

2017 $

2018 $

2019 $

2020 $

(c)	Units-of-production

Year Depreciation expense

2016 $

2017 $

2018 $

2019 $

2020 $

3.	Using your answers to requirements 1 and 2, determine net income and the two loan covenant ratios in each year, assuming the company chooses the following depreciation methods:

(a)	Straight-line (Enter your answers for Net Income in thousands (i.e., 50,500 should be entered as 50.5). Round "Net Income" to 1 decimal place and "Ratio Values" to 2 decimal places.)

Net income

Times interest earned ratio

Fixed asset turnover ratio

(b)	Double-declining-balance (Enter your answers for Net Income in thousands (i.e., 50,500 should be entered as 50.5). Round "Net Income" to 1 decimal place and "Ratio Values" to 2 decimal places.)

(c)	Units-of-production (Enter your answers for Net Income in thousands (i.e., 50,500 should be entered as 50.5). Round "Net Income" to 1 decimal place and "Ratio Values" to 2 decimal places.)

4.	Using your answers to requirement 3, indicate whether the loan covenants would be violated under the following depreciation methods:

Need assistance with calculations for the tables, everything filled in so far is correct

.

Answer 1

1. Amount of interest expense per year= 0.06x 1,260,000

= $75,600

2. Depreciation expense:

(a) Straight-line Method

Cost of Vehicles    14,00,000

Sales Tax              14,000

Total Cost             14,14,000

Salvage Value     280,000

Depreciation expense per year= (14,14,000- 280000)/ 5 = $226,800

3. We assume a tax rate of 21% to calculate the Net Income as it is not given.

4. Loan Covenants

We find that the for each of the methods

Times interest earned ratio > 3 for all the years

Fixed asset turnover ratio > 1 for all the years

So, the loan covenants are not violated in any of the methods.