Fundamentals of Financial Accounting 4th Edition by Fred Phillips,Robert Libby,Patricia Libby

Exercise 32

Calculating Interest and Depreciation Expenses and Effects on Loan Covenant Ratios (Chapters 9 and 10)
Zoom Car Corporation (ZCC) plans to purchase approximately 100 vehicles on December 31, 2012, for $2 million, plus 11 percent total sales tax. ZCC expects to use the vehicles for 5 years, and then sell them for approximately $420,000. ZCC anticipates the following average vehicle use over each year ended December 31:

To finance the purchase, ZCC signed a 5-year promissory note on December 31, 2012, for $1.8 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.)

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, (b) double declining-balance, (c) units-of-production.
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, (b) double declining-balance, (c) units-of-production.
4. Using your answers to requirement 3, indicate whether the loan covenants would be violated under the following depreciation methods: (a) straight-line, (b) double declining-balance, (c) units-of-production.