# 2 important concepts from FRA!!

Hi guys,

I would appreciate if someone from you could confirm or comment whether the below approaches are correct fort he couple of concepts I personally consider very important:

1, Adjustment of EBIT/Interest from Operating Lease to Fin. Lease:

EBIT= EBIT + annual operating expense – related depreciation

Interest = Existing Interest expense only

you do not add Interest expense from Fin. Leasing since it´s EBIT, if you would calculate EBT, you would add interest from Fin Leasing (calculated: Interest*PV of lease payments)

Annual operating expense = usually given

Depreciation = PV of the lease payments divided by number of years (life of the equipment)

2, Adjustment of EBIT/Interest from capitalizing to expensing:

EBIT= EBIT – capitalized expenses/interest + related depreciation

Interest = Existing Interest expense + capitalized expenses/interest

Sorry if those topics were answered already before but I think that this material is so important that it would be good to have a summary on a clear calculation approach on both above topics.

Thanks a lot in advance for taking time!

Some example plz

I remember going through a BB that explained this very well. Of course, i dont recall anything but your first statement - thanks for bringing this to my attention.

this looks very much like schweser. they may have given you a good summary, but unless you internalize what is going on here just memorizing this is going to STUMP you on the exam day. speaking from experience.

also try to assess how going back and forth between ops lease vs fin lease, how do they affect your Cash flow, taxes, ratios, etc. that’ll give you a firm handle. i’d hit the book cuz I myself have no clue how to do these.

maybe someone can help here??? i dont think you need an example here, just imagine what would you usually add and deduct when adjusting for the above.

Would really appreciate if someone could help on this!

thanks again

which formula is correct? can you give the page numbers?

Take a look at the example on page 54 curriculum. It will clarify a lot.

I would actually add the interest on finance lease to the denominator as is constitutes a fixed obligation as ony other interes on long term debt and is on operatin outflow. I recall doing one example where interest coverage ratio had (EBIT + rental expense - dep) in nominator and (interest expense + interese from finance lease) in denomiator.

yes, thats true interest on financial lease shoul be added to denominator, thank you for this

For Interest coverage ratio (capitalizing --> expensing), you only need to add related depreciation back to the nominator, and capitalized interest to the denominator.

For Interest coverage ratio (capitalizing --> expensing), you only need to add related depreciation back to the nominator, and capitalized interest to the denominator.

I am not quite sure about capitalizing interest expense, because on the CFAI EOC problem 8 (Book 2, pages 99 & 102) they say that interest coverage ratio doesn’t change by capitalizing interest expense because it is based on interest payments and not expense. Can anybody who is 100% sure about difference between capitalising vs. expensing and it’s impact on EBIT/interest explain this better.

When capitalized interest is converted back to expense, interest coverage ratio would be lower. The idea is very simple, a lump sum equals to the sum of capitalized interest is added back to the interest expense because this lump sum is supposed to be expensed as incurred. On the other hand, related depreciation is added back to EBIT because capitalized interest are allocated to dep exp or COGS in the subsequent years. In the case when the interest is expensed as incurred, this depreciation would not have occurred. Therefore, to reverse the affect of capitalization, depreciation —> EBIT.

repeated msg*

Take a look at the problem mentioned, is it an error in the material then?

Do you know where does the interest come from? It comes from the process of constructing an asset, and it’s a cost. Even if it is a payment, it is payable to others, and doesn’t change the fact that it is a cost. Wording problem, no big deal.

repeated msg* fck my company’s computer sucks.

I was wondering something along similar lines, and the discussion above didn’t fully clear it up for me.

Schweser notes say that capitalizing interest improves the interest coverage ratio because it reduces income expense(the denominator).

EOC q’s from the cfa books indicate that the interest coverage ratio is unnaffected by capitalizing interest instead of expensing it because the interest coverage ratio is calculated by as EBIT/interest payments(instead of interest expense)

In this situation I’m guessing you should put your faith in the official books instead of Schweser and do so for all other conflicts?

Thanks