Amortization of debt under purchase method

I was reviewing FSA and stumbled upon this concept I must have missed before. When a firm acquires another firm whose book value of long term debt is greater than the current fair value, why is interest expense INCREASED at the difference is amortized from book value to fair value? Under the purchase method assets and liabilities are restated to fair value, so wouldn’t the fact that the debt they owe isn’t worth as much be a benefit to them and cause interest expense to decrease? This is from example 8 on page 30 of the CFAI book and the place where it says interest expense increases is on the bottom of page 35. Basically, for the acuired firm, BV of LTD = $2,000 while Fair Value = $1,800. It says under the purchase method interest expense is higher under the purchase method, which reflects the amortization of the undervalued debt.

I do not have the book in front of me so i’m taking a stab at the problem blindly. If BV of debt > MV of debt then that means the debt is trading at a discount which means that the company is slowly amortizating the BV of the debt. Under the purchase the debt is re-market at MV so it means on its income statement it is going to report the increase discount to report it back to par increasing interest exp.

Maybe its b/c I haven’t had enough sleep, but could you explain why if the BV of debt > MV it means the debt is trading at a discount? Isn’t the BV based on market interest rates when the debt is issued? So if the bond pays 6% when the market rates are 8% it will have to be issued at a discount. If BV > MV doesn’t it just mean that interest rates have decreased since it was issued to the point where if you issued it now you’d get more for it? So couldn’t the debt have been issued at par, a premium, or a discount? I know I’m wrong, but I’m just not seeing what’s going on here.

Bradley, can you give me the book and page #? I want to take a look at this when i get back home.

Sure, page 30 of the CFAI text, example 8 shows the BV and FV of debt. The bottom of page 35 mentions interest expense being higher under the purchase method.

I looked at the problem. The way I reason it in my mind is that… The bond was trading at a discount sine MV

I think you have to look at this way. Granted all long term bond values have to be amortized to meet par values by maturity date. But once you reevaluate , you are amortizing to meet BV, old book value not to par value. So this amortization is on top of the amortization to reach par value by maturity date -which does not change. We have no idea whether old BV > PV , = PV or

Different cost basis for pooling/purchase method.