Capitalizing Interest

CFA Level I
#1

In page 425 of the Vol 3 curriculum, there is an example of capitalizing interest (of $1,301) and calculating interest coverage ratio. If the interest is capitalized then interest coverage ratio = EBIT / Interest Expense = 25,736/12,179 = 2.11 If the interest interest in not capitalized then it is added to Interest Expense and the interest coverage ratio = EBIT / (Interest Expense + Capitalized Interest) = 25,736/(12,179 + 1,301) = 1.91 The above is what the curriculum says. However, I would think that if the interest was not capitalized and instead expensed, then EBIT should also decrease. The capitalized interest is not an expense and hence is not subtracted in calculating EBIT. If it is not capitalized then it should be subtracted to calculate EBIT. Any thoughts? NC

#2

EBIT is earnings before interest and taxes, that is why it is not included

#3

starbuk Wrote: ------------------------------------------------------- > EBIT is earnings before interest and taxes, that > is why it is not included But of course, missed that one! There however seems to be a problem with the next part. It says that the decline of CFO will be 1,301 (because by not capitalizing it will be deducted from CFO rather than CFI). However, taxes will fall as a result of not capitalizing. This will increase CFO and this has not been accounted for. Thanks, NC

#4

The point is, whenever the firm expenses rather than capitalizes, its EBT should go down, and therefore taxes should go down. Taxes impact CFO. The curriculum seems to make the same mistake in the 4th paragraph page 430 V3, when it only considers the impact of moving the cash spent on development from CFI to CFO and ignores changes in taxes. NC

#5

I think that they ignore the change in taxes because the outflow from CFO and inflow to CFI outweigh the changes in Taxes. The goal here is to see which part of the SCF is affected and in what direction they go in.

#6

gcgrossm Wrote: ------------------------------------------------------- > I think that they ignore the change in taxes > because the outflow from CFO and inflow to CFI > outweigh the changes in Taxes. The goal here is to > see which part of the SCF is affected and in what > direction they go in. Agreed that the change in tax will be outweighed by the change in expense (after all the tax is around 36% of the change in expense). However the problem with these questions is that they actually provide numbers, rather than just asking what will increase or decrease. NC

#7

So are we agreed that the omission of tax by the textbook a mistake? NC

#8

The omission of taxes is not a mistake. You are assuming that the company’s income tax expense equals taxes payable. As you will learn when you study taxes, the actual cash payment for taxes can be quite different from the income tax expense computed by simply applying the statutory tax rate to pretax income on the income statement. The difference in actual cash outflow resulting from expense recognition or capitalizing the expense depends on the ‘tax return’ treatment of the item (i.e. whether it is tax deductible or not), not on its treatment on the income statement. Perhaps some CPA could contribute more to the discussion.