Hi, I have a question regarding Example 6 (CFA 2019 L1 Vol 3- P392).
In the solution to the example, it says
“If the interest had been expensed rather than capitalized, financing cash flows would have been higher in all three years.”
Should it be investing CF that would have been higher, rather than financing CF, since capitalized interest reduces investing CF?
I appreciate any help in advance.
I believe you’re generally right (at least for US GAAP). Capitalized interest rolls into the long-term asset balance, and will be included as a part of depreciation expense. So if a construction project costs $100 million and you borrow funds the entire amount to finance the project and in additional incur $10 million interest. The accounting journal entry would be.
Construction Project (long-term asset) (debit) $110
Cash outflow from investing (credit) $110
Essentially that $10 million is rolled into the cash from investing outflow as cash spent on the project.
But if you expensed in the interest instead, it would it would reduce net income by $10 million and that $10 million would reduce net income and therefore reduce cash from operations.
However this could be something to do with deferred financing costs in the last paragraph of the question (which the curriculum doesn’t address). But that is only a guess.
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Thank you for your detailed clarification. That helps me a lot.