What effect does a $10 increase in depreciation have on the income statement?

The correct answer is that net income decreases by $8 after taxes because of the tax impact associated with the increase in depreciation expense. When depreciation expense increases, it directly reduces taxable income since depreciation is a non-cash expense.

For example, if depreciation increases by $10, this will reduce the pre-tax income by $10. Assuming a corporate tax rate (let's say 21% for context), the tax savings from this additional depreciation would be $10 multiplied by the tax rate, which equals $2. Therefore, the effective reduction in net income after accounting for taxes would be:

Net reduction in income = Increase in depreciation - Tax savings

= $10 - $2

= $8

This demonstrates how an increase in depreciation can lead to a decrease in net income, but the tax shield created by the depreciation mitigates some of that impact, resulting in a net decrease of $8.