EBIT and capitalization of interest expense? actually, interest, increase, decrease

mdfb79

Please don't kill me for bringing up this matter again, but it's still way beyond my understanding. The answer to a specific question states that "since interest cost is $10 million, capitalize interest cost would increase EBIT by $10m." I always thought that since interest cost is recorded below EBIT, so when capitalize and amortize the interest expense, EBIT would actually decrease, not increase by the exact amount of interest expense.

Could someone please explain to me? Thanks so much!

ap0258

Doesn't make sense to me either....

Capitalizing interest should decrease interest costs & increase assets. EBITDA stays the same, however depreciation increases, resulting in a decrease in EBIT.

The decrease in interest costs is larger than the increase in depreciation (assuming anything other than 1 yr depreciation w/ 0 salvage value) and results in a higher NI.

stalkey

Difference is that if you do NOT treat it as a capitalized interest , you most probably expensed it to the full extent i.e. $10 m.

Now when you reverse that and capitalize it , yes you shove the $10 m from above operating income line to below it , so you INCREASE EBIT .

Think leasing versus capitalizing

5566

When expense: record $10m below EBIT and as interest expense

When capitalize: record $10m as assets, thus reducing interest expense by $10m, up to this point, EBIT unchanged. Then if you amortize $10m assets, EBIT will actually decrease.

Thus, sorry but I still don't understand your explanation. And what about leasing vs capitalizing? Please kindly help.

ningning1984

If you capitalize some payments , you effectively treat them as debt and the payments on it are not an operating expense.

If you avoid capitalizing them , as WalMart and some others like JetBlue have done , you treat it as lease payments i.e. rentals, which are operating expense.

Your choice will drive higher EBIT ( capitalizing ) or lower EBIT ( leasing/renting ).

You may ask why anyone would do that. Its to show less assets on your bs and therefore show less leverag, making you look better to a foolish investment community



Edited 1 time(s). Last edit at Thursday, June 3, 2010 at 11:08PM by janakisri.

liquidity

janakisri Wrote:
-------------------------------------------------------
> If you capitalize some payments , you effectively
> treat them as debt and the payments on it are not
> an operating expense.
>
> If you avoid capitalizing them , as WalMart and
> some others like JetBlue have done , you treat it
> as lease payments i.e. rentals, which are
> operating expense.
>
> Your choice will drive higher EBIT ( capitalizing
> ) or lower EBIT ( leasing/renting ).
>
> You may ask why anyone would do that. Its to show
> less assets on your bs and therefore show less
> leverag, making you look better to a foolish
> investment community


+1. You have covered both areas. The Income effect and the BS explanation.

yospaghetti

janakisri Wrote:
-------------------------------------------------------

> Your choice will drive higher EBIT ( capitalizing
> ) or lower EBIT ( leasing/renting ).
>
> You may ask why anyone would do that. Its to show
> less assets on your bs and therefore show less
> leverag, making you look better to a foolish
> investment community


Think I got it now, thanks very much! "Its to show less assets on your bs and therefore show less leverage", my favorite statement of the day!

tobeornottobe

calgaryeng123 Wrote:
-------------------------------------------------------
> Janakisri : the explanation on lease vs.
> capitalize makes perfect sense and I am on top of
> that. However your first post still does not make
> sense to me. Lets look at an example - the
> question is asking what happens to EBIT when you
> capitalize an interest cost instead of expensing
> it.
>
> Case I - Interest expensed
>
> Gross Profit : 100
> Depreciation : 10
>
> ** EBIT ** = $90
>
> Interest Expense : 20
> Taxes @ 30% : 21
> NI : 49
>
> Case II - Interest Capitalized
> --> 20 added to assets. assume 5 yr depcn, no
> salvage value = $4
>
> Gross Profit : 100
> Depreciation : 14
>
> ** EBIT ** = $86
>
> Interest Expense : 0
> Taxes @ 30% : $25.8
> NI : $60.2
>
> ________________
>
> Therefore as I stated earlier - capitalizing
> interest instead of expensing:
> - Has no effect on EBITDA
> - DECREASES EBIT
> - increases NI in the first year, decreases in
> later years (vs. base case)


That's exactly as I thought, but the answer from the test seems to disagree, I'm gonna memorize that capitalizing interest expense will increase EBIT, leasing/rental will decrease it, just as janakisri said. Maybe there's some correct reasons for it, and whatever it is, it's beyond me.

wilslm

No, not taken out of context, the question asked about interest on construction projects, not operating lease.

hassan

you are losing the entire point.

Year 1 was 2007 in the sample exam when Cap Interest was the 64 Mill.
Year 1: X amount of Sales - COGS
Year 1: High amount of Capitalized Interest Asset So High depreciation.
Year 1: EBIT is lower.

Between Year 1 and Year 2: a large amount of the capitalized Interest asset got paid off. Year 2: 2008 when capitalized Interest account balance was the 30 Mill or there abouts.
So Year 2: Depreciation expense is lower.
So Year 2: EBIT is higher WHEN COMPARED TO THE EBIT that would have been if the Capitalized Interest Balance sheet account HAD BEEN THE SAME AS IN 2007.

Does that distinction make sense?

CP