Effect of interest cost that is capitalized/expensed

CFA Level II
#1

In curriculum reading 16 (long lived assets), practice problem Question 8 is about comparing between capitalizing and expensing the interest cost related to construction of a machine. I checked the solution explanation and it says interest coverage ratio should be unchanged whether the interest cost is capitalized or expensed cause interest payment includes both capitalized and expensed interest. But the reasoning has omitted the change regarding EBIT.

Since interest coverage ratio=EBIT/interest payment, the explanation is true regarding that interest payment includes expensed and capitalized interest, but what about EBIT? If interest cost is capitalized, EBIT will surely decrease cause of increased depreciation since the machine is built for its own use and therefore the interest cost will become part of the asset subject to depreciation.

The answer should still be B, but I think the explanation is not correct.

Does anyone have same thinking?

#2

Yep, I think you’re right. As the capitalized interest is part of the fixed assets, it is included in the depreciation (expense) and will therefore result in lower EBIT and hence a lower interest coverage ratio. So it probably won’t be “unchanged” as mentioned in the answer.

Though I guess the main takeaway for this q is to remember to include interest payments rather than interest expense in the denominator of the formula. That part remains unchanged.

#3

smiley