A company runs into financial distress and sells a factory at book value 100 for 80 with a 40% tax rate. What is the effect on Net Income?

A company runs into financial distress and sells a factory at book value 100 for 80 with a 40% tax rate. What is the effect on Net Income?

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

Answer: (A)

Selling an asset for less than its carrying amount creates a pre-tax loss equal to the difference, here 20. This loss reduces pre-tax income by 20. The tax saving from the loss (tax shield) is 40% of that amount, which is 8. Net income reflects both the loss and the tax benefit, so the change is -20 + 8 = -12. In other words, net income decreases by 12. The key idea is that a loss lowers taxable income, producing a tax shield that offsets part of the loss.

Selling an asset for less than its carrying amount creates a pre-tax loss equal to the difference, here 20. This loss reduces pre-tax income by 20. The tax saving from the loss (tax shield) is 40% of that amount, which is 8. Net income reflects both the loss and the tax benefit, so the change is -20 + 8 = -12. In other words, net income decreases by 12. The key idea is that a loss lowers taxable income, producing a tax shield that offsets part of the loss.