Capitalized interest

CFA Level II
#1

  1. Capitalizing interest does not affect the interest coverage ratio (EBIT/interest expense).

  2. Interest expense in the calculation of the interest coverage ratio is, in substance, interest payment.

  3. Since capitalizing interest has no impact on interest payment, there is no change in the interest coverage ratio.

This is the logic used in practical problems 8 of the curriculum book (p105)

I am skeptical of the point that interest expense is equated with interest payment in the calculation of the interest coverage ratio.

Would you please share your wisdom with me?

#2

interest capitalization is making your interest payment a part of the “capital” purchase you are making - and that gets added to the price of the “purchase” - and gets depreciated over time.

Interest payment is the “actual” interest you pay - so that is correct - it is the interest expense.

hence when you capitalize your interest - your interest coverage = EBIT / Interest Expense -> will change.

#3

Hi, thanks for the message

tax expense is not always equated with tax payment.

But interest expense is always equal to interest payment.

Am I correct?^^

#4

You’re not. There is such term as “interest accrued” (not paid yet) or in later periods interest can be added to principal in real life.

#5

I beg to differ, based on the curriculum book (page 105 # 8 solution)

“Capitalized interest appears on the balance sheet as part of the asset being constructed instead of being reported as interest expense in the period incurred. However, the interest coverage ratio should be based on interest payments, not interest expense (earnings before interest and taxes/interest payments), and should be unchanged.”

#6

Excluding interest that gets capitalized doesn’t make any sense. Capitlaized Interest is cash spent on interest just the same. If there is an exam quesiton, I am using Cash Payments on Interest, if it is given. Using Interest Expense has at least two issues: a) missing capitalized interest as just noted, b) interest expense almost definitley will have non-cash amortization in it

Using Cash Payments on Interest has the problem of comapring a cash basis figure (Cash Payments on Interest) with an accrual basis figure (EBIT), bu tthat is less of a problem, IMO.