What would be the effect of capitalizing interest costs on EBIT? I understand that NI will increase but not sure how EBIT will be affected?
no effect on EBIT. EBIT is decided before the interest expense even comes into play: Rev - CoGS = gross profit - SG&A = EBIT - int expense = EBT - taxes =NI the only thing that would change is that the interest expense that you’re capitalizing no longer shows up in this. so whether you’re capitalizing $100 or $99999, EBIT will be the same, as you can see above. As you mentioned tho, NI would be affected. NI would increased by: (capitalized interest amount)(1-T) On a related topic though, if you’re capitalizing a lease payment, that’s a different story. Lease payments go into either your CoGS or your SG & A (i forget which, probably SG & A), so EBIT would be affected. the formula to figure the difference is pretty easy though: EBIT capital lease = EBIT operating lease + lease PMT - (PV of lease PMTs)/(# of years)
faraz70s Wrote: ------------------------------------------------------- > What would be the effect of capitalizing interest > costs on EBIT? I understand that NI will increase > but not sure how EBIT will be affected? NI will increase ONLY in the first year. Subsequesnt years, expensing has higher NI. EBIT will decrease. When you expense interest, it does not affect EBIT. When you capitalize interest, the corresponding depreciation becomes a part of that yr’s EBIT and as a result reduces EBIT.
^ yeah, if you do that, i agree. he never said anything about depreciation, but w/e
If it’s an asset that’s in progress over the course of several years though, you wouldn’t depriciate it, and ebit would remain unaffected.
Thanks guys, but there’s a question in Mock (Morning)Q 39 where it says that it would increase EBIT? I thought it should reduce EBIT.
look, heres the situation, ive been to every nation, and they must capitalize the interest.
seems incorrect
wake, what are you talking about
Assuming it’s not the first year of any captilized interest cost, you usually need to adjust EBIT for depreciation of captilized interest. Same goes for interest expense. If you are performing ratio analyses between two firms, you need to make these adjustment to get them on the same basis. [e.g. Interest coverage ratio = (EBIT / Interest expense)] The problem would have to let you know either by saying so, or there is a breakdown of depreciation costs that shows the interest component.
magicskyfairy Wrote: ------------------------------------------------------- > wake, what are you talking about its Enrique Inglesias song
wake2000 Wrote: ------------------------------------------------------- > magicskyfairy Wrote: > -------------------------------------------------- > ----- > > wake, what are you talking about > > > its Enrique Inglesias song Is that like some kind of Mexican Jonas Brothers guy?
magicskyfairy Wrote: > > Is that like some kind of Mexican Jonas Brothers > guy? More like a spanish 30-something Willow Smith…
magicskyfairy Wrote: ------------------------------------------------------- > wake2000 Wrote: > -------------------------------------------------- > ----- > > magicskyfairy Wrote: > > > -------------------------------------------------- > > > ----- > > > wake, what are you talking about > > > > > > its Enrique Inglesias song > > > Is that like some kind of Mexican Jonas Brothers > guy? precisely, with a delicately place mole
right. anyway, to answer this guy’s question, the only way EBIT would increase by capitalizing is if the situation we’re talking about is a capital lease vs an operating lease on some asset. consider this situation: Lease PMT $200, r = 5%, lease term = 10 years, PV = 1544.35 o In the first year of the lease, you would have: - Lease payment of $200 - Interest expense of $77.22 (operating CF) - Principal Payment of $122.78 (investing CF) - End of year lease PV of 1421.57 (1544.35 – 122.78) - Depreciation expense of whatever; (management would choose depreciation method) I already showed the formula -> EBIT capital lease = EBIT operating lease + lease PMT - (PV of lease PMTs)/(# of years) suppose the EBIT at the end of the year under an operating lease is $100; we can now solve for the EBIT under a capital lease with the formula: EBIT capital lease = 100 + 200 - (1421.57/9) = $142.05 there is also a depreciation expense to worry about. as long as the related depreciation is less than 42.05, then EBIT after capitalizing the interest will be greater than if you’d just expensed the whole payment. of course, if you went with a capital lease, and decided to just expense the interest payments rather than capitalize and depreciate them, then you’d still end up in a situation where the EBIT you have by NOT capitalizing is greater than the EBIT you’d have by capitalizing, so I’m really not sure why this question thinks capitalizing leads you to higher EBIT.
long story short, capitalizing your interest will increase your depreciation expense (assuming you depreciate the asset in the same year you incur the interest expense), which will lower your EBIT. not capitalizing your interest will increase your interest expense (relative to capitalizing it), but that has no effect on EBIT, so EBIT will be unaffected by the interest expense, however large or small it is.
MSF, how about interest from financing self-contructed, long-term assests? These interest costs are capitalized (like the asset), and depreciated (in tandum with the asset). These are interest costs that will not affect the EBIT the first year (no depreciation; ignore interest costs anyway), and will lower EBIT in subsequent years via depreciation. So, in year 2, to get true EBIT, you would take EBIT + depreciation (portion of captilized expense), no? That’s the base case that comes to my mind.
Are they? I dunno, you could be right, but I found a few sources online telling me you can’t depreciate stuff until it’s considered complete. But to be honest, I don’t know that much about all the ins and outs of stuff you can and can’t capitalize, so you may be right. Either way, I don’t think it’s something I need to be too concerned about for this exam. My point is just that I can’t think of any way for EBIT to be greater by capitalizing interest than by expensing it; I only see it as possible for it to be equal or lower. And lets be honest, the extent to which your depreciation expense for the year would increase by capitalizing one year’s worth of interest expense… relatively speaking, it couldn’t make that much of a difference to EBIT. to show you what I mean, let’s run with this example: Lease PMT $200, r = 5%, lease term = 10 years, PV = 1544.35 o In the first year of the lease, you would have: - Lease payment of $200 - Interest expense of $77.22 (operating CF) - Principal Payment of $122.78 (Financing CF)