The management of Company Z is considering two proposals for expanding its current production capacity. Option A is to construct a new facility at a cost of $100 million, a project that will take up to one year to complete. Option B is to purchase an already operational facility from a competitor for the same amount and that will be available for use about the same time. To fund either project, the company will use the proceeds from an already planned issuance of $60 million in long-term debt at a projected after-tax cost of 6%. Management desires to minimize the impact on the interest coverage ratio and reported operating cash flow. Which of the following reflects the most likely effects of the alternative proposals? Higher interest coverage ratio ----------- Higher Operating Cash Flow a. Option A Option B b. Option A Option A c. Option B Option A d. Option B Option B - Dinesh S
I would pick d
i think it’s b. with option a, you can capitalize the interest of the construction, so interest expense is lower, hence higher interest coverage, also, with lower interest, NI is higher, so CFO is higher, with lower CFI
i agree with liaaba and chadtap. it all comes down to capitalizing interest in project A.
concur with b…
Good question. I suspect you’re right that it is B; but could you post the correct answer Dinesh?
I don’t have access to Passmaster at office, I’ll paste the answer the moment I reach home.
B - liaaba nailed it.
Choice “b” is correct. Under U.S. GAAP, the company will capitalize a portion of its interest costs during the construction period of Option A. There is no provision for capitalizing interest expense when an asset is purchased in a ready-to-use state. As a result, Option A will result in lower periodic interest expense and a higher interest coverage ratio as compared to Option B. In addition, Option A will also result in a higher reported operating cash flow due to the fact that the capitalized portion of interest payments will be reported as an investing outflow on the statement of cash flows, rather than an operating cash flow where “expensed” interest payments are reported. - Dinesh S