Capital Budgeting - Accounting Income

[brisby55]

Hey guys, quick question regarding Accounting Income
There’s an example in Schweser on pg. 234. Basically, you’re investing $400,000 in a project (50% equity, 50% debt with 6% interest rate). Why when calculting the Interest Expense do we calculate it based on the Market Value of the debt (which they say is the PV of the remaining cash flows) and not on the $200,000 of debt outstanding?
I find this pretty confusing…any help would be appreciated….thanks

 

[sgupta0827]

Remember balace sheet accounts do not reflect the current market value, but interest is calculated based on current market value, so 200K is not the appropriate amount to be considered while calculating interest. Makes sense?

 

[sunnyisready]

sgupta - it is true that b/s accounts (generally) do not reflect the market values, but the interest expense is calculated based on the outstanding principal balance - which is the book value of the debt in the absence of amortized discounts/premiums. changes in the market value of the debt have no effects on the interest expenses as long as the debt in question is not based on floating rates.
brisby - the reason why the market value is used in the schweser example is related to the fact that the target capital structure is based on the market value. if you assume the company maintains the 50/50 target ratio at all times, its debt balance will constantly be adjusted depending on the market value of the company, and they’ll have to pay interest on this amount.