Same question as the previous but the company finances the purchase of equipment by issuing debt rather than paying cash.

First Year:  Income Statement:  No depreciation and no interest expense so no change.  Cash Flow Statement:  No change to net income so no change to cash flow from operations.  Just like the previous question, we’ve got a $100 increase in capex so there is a $100 use of cash in cash flow from investing activities.  Now, however, in our cash flows from financing section, we’ve got an increase in debt of $100 (source of cash).  Net effect is no change to cash.  Balance Sheet:  No change to cash (asset), PP&E (asset) up $100 and debt (liability) up $100 so we balance.

Second Year:  Same depreciation and tax assumptions as previously.  Let’s also assume a 10% interest rate on the debt and no debt amortization.  Income Statement:  Just like the previous question:  $20 of depreciation but now we also have $10 of interest expense.  Net result is a $18 reduction to net income ($30 x (1 – 40%)).  Cash Flow Statement:  Net income down $18 and depreciation up $20.  No change to cash flow from investing or financing activities (if we assumed some debt amortization, we would have a use of cash in financing activities).  Net effect is cash up $2.  Balance Sheet:  Cash (asset) up $2 and PP&E (asset) down $20 so left side of balance sheet down $18.  Retained earnings (shareholders’ equity) down $18 and voila, we are balanced.