Capitalizing Interest Costs understand, net, interest, increase, something

parott

How does capitalizing interest expense increase EBIT? I understand that capitalizing interest costs would increase net income by the amount of interest capitalized less the amount that is amortized in the year. However, since EBIT is obviously earnings BEFORE INTEREST and taxes wouldn’t capitalizing interest have no effect on EBIT? Or am I missing something here? This is related to problem #39 on the morning session of the mock exam.

defour44

I figured out how they screwed up the answer key. The correct answer is absolutely C.

The reason why the answer key is wrong is because they mislabeled the figures in the original question and the answer key person got confused. Follow me here:

If you look at the Income Statement all values are denoted in thousands.

This means 3,510 in reported expenses is 3 million, 510k in expenses.

Now go to the footnotes.

The footnotes say Interest Costs (in *MILLIONS*)

What CFA is NOW saying here is now that the interest expense is 3 billion 510 million a year. It makes 0 sense. How does a company doing 1.1 B in revenues have 3.5 billion in interest costs. Whatever, let's go with it 30 K in capitalized interest expenses is now a huge 30 million.


Then you go to the answer key and what should have been the $4.0 M in software capitalization expense being greater than the 30,000 in interest cost is now LESS than the 30 million in interest costs, so they picked interest costs as the answer.

If they had properly labeled the figures, it would have come out to software development capitalization increasing EBIT the most, not interest costs.


I sat for 5 mins looking at these figures going.. WTF... ??? wtf ??? how are they booking 3.5 billion in interest costs on a $1.1 B topline business. these guys are Enron^2.

sameeragarwal

Agreed. EBIT is the same at time 0 and would be lower by depreciation amount (interest portion) in following periods.

Uranus08

Has to be errata, has to be

- Guille

tarunajwani

The only thing i can think of is that it is the full amount of the capitalization vs. Expensing it in that given year

But yes again as you say, even so it affects the interest expense line.

That's it im not sleeping tonight

- Guille

tikfed

they dont provide alot of explanation. all they say is that capitalizing the interest increased EBIT by a certain dollar amount. ive kept my explanation general, so as to not spoil it for you.

giorgio10

What does the answer sheet say? This is a spoiler for me (taking the mock tomorrow)

- Guille

redskins44

yes you are correct, however from my understanding, the year that you capitalize is the current period, which is lets say time 0 for illustration, you would then incurr depreciation at time 1 and so on. but at time 0 you would incur no interest expense since the interest has been capitalized. i hope im making sense

WarrenB1

Project costs $100 million. If you get a loan for $100 million and you don't capitalize interest, your depreciation is $10 million (straight line, 10 years). EBIT= -$10 million.
If you calitalize interest, your asset is say $140 million, depreciation is $14 million. Your EBIT=-$14 million. EBIT under capitalized interest is lower.
No?

kickthatcfa

@guille i get ya, however both EBIT under capitalizing or under expensing would initially be equal since interest expense does not impact the calculation of EBIT. i don't see how EBIT could be relatively higher or lower under either method in the initial time period....