Capitalization Vs. Expensing.

D/E ratio. Is it higher under Capitalization or Expensing? I thought Capitalizing create net Liability and hence D/E goes up. For Expensing (in the early years at least, equity is reduced by lower N.I. and hence higher D/E ratio). Am i missing anything here? Thanks in advance for any insights into this.

im sure the liability effect is greater than the equity effect

actually, capitalising expenses does not have anything to do with debt… you’re thinking of a CAPITAL LEASE, which does increase debt… but in terms of capitalising expenses, in general, it increases equity (the way that you mentioned, through a higher net income) and thus will lead to LOWER leverage ratios… but im the same, im always getting mixed up between “capitalizing” and “capital lease”

So, let me see if I got this right: For expenses: Capitalize Expenses: Assets up Equity up Capitalized cost - CFI out Depreciation expense - CFO out Expensing: Expenses - CFO out sum of both are the same For Leases: Capitalize Lease: Assets up Liability up Depreciation expense - CFO out Interest expense - CFI out (higher in early years, lower in later years) Operating Lease: Operating expense - CFO out sum of both are same.

^ Looks good to me. Nice summary

bingo thanks for posting this question up btw…i never really took teh time to think about the distinct differences before, until now…

I got the same question wrong in CFAI Exam 4

i reckon alot of people get this concept mixed up

D/E if you expense, your income will be lower, if lower income, equity will be lower, hence D/E will be HIGHER

^thats right capitalising leads to LOWER leverage ratios… therefore expensing leads to HIGHER leverage ratios

Depreciation does not affect cash flow.

so, a better way to say it is that: Capitalizing expenses: depreciation expense increases CFI decreases in the first year instead of CFO Capitalizing leases: depreciation expense increases CFI decreases (higher in earlier years, lower in later years) instead of CFO ?

For capitalizing leases, cash flow for the lease income for the lessor should be distributed between CFO and CFI, while cash flow for the lease payment for lessee should be distributed between CFO and CFF. Think it as this: - For capitalized lessee, payment is divided between interest expense and Principle reduction in liability, so interest expense go to CFO and principle reduction of liability go to CFF. - For capitalized lessor, payment is divided between interest income and a reduction in net investment in lease, so interest income goes to CFO and reduction in investment goes to CFI. - For CFI ammount (that is assume in the lessor perspective), since the CFI inflow is (lease income - implicit interest rate * net investment in lease), and net investment in lease decreases over time, so CFI inflow actually will become higher in later years.