Capitalisation of Interest

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level1_dec

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For companies in an expansion phase, capitalisation of interest may result in a gain in earnings over an extended period because:
A. The amount of interest amortisation will not catch up with the amount of interest capitalised in the current period;
B. The average projected expenditures for the period exceed specific borrowings;
C. The cost of financing project debt exceeds the cost of equity finance;
D. Earnings are greater under capitalisation than under the expense method over the life of the qualifying asset.
i think answer is c, definately not d as by capitalising , depreciation would increase in income statement hence decreasing net income
 
A. By captalizing interest, earings is reduced by armotization. Comparing with expensing interest in the scenario of expansion, armortization of interest would always be less than the interest itself.
It concerns comparison between captalizing interest and expensing interest, not about debt financing and equity financing.
 
hi mel_2008, this question is in highly co related with Balance sheet & income statement topic
 
OK, thanks. Haven’t crossed that bridge yet…
Still finishing up Quant. Then moving to Econ. I’ll keet this post in mind, though, for later on…
 
Why are we ruling out option D here?
May be I am not getting the concept right.But with capitalising the interest we should get more Net Income as expensed interest amount will be more than capitalized.So we should expect more earnings.(Not just for expansion phase but also for life of an asset.)
In option A, I am not able to understand the difference between
“The amount of interest amortisation” and “the amount of interest capitalised “.
Please explain
Thanks
 
you capitalized the interest and then you amortize the whole thing. So when you are in a expansion phase, you spend more on fixed capital and you capitalize more interset, therefore , amortizing the interest will not catch up with the added capitalized interest. Example, think of amortization as depreciation it is the same thing just different word. first year you capitalized 1000 in interest. at the end of the year you amortized 20 dollars, and next year you will amortize 20 dollars untill the whole capitalize interset is gone. HOWEVER, during the second year, you capitalized another 1000 dollars becuase you are in the expansion phase, you amortization will go up to 40 dollars, so if you realized that amortization will not catch with capitalized interest if you are in the expansion phase. the reason it result in gain in earning, if you expensed you will expense the whole 1000 dollars which will decrease Net income, but in this case you only decrease revenues by 40 dollars of amortization.
You GOT IT
 
This is an important concept to understand as you move on to deferred assets/liabilities. ssdnola explained it very well.
 
hii ssdnola,
you look very well prepared for he exam, what is your background and and your game plan for exam. i am very intrested to know how far have you reached with your preparation. what course material are you following for e.g schwser then cfa end of reading questions or just cfa text
thanks
 
i was just reading this section in schweser. the wording is verbatim.
 
Dear ssdnola
Thanks for very good explaination
To summarize can we say
During the construction time (Expansion time) due to capitalization
CFO,NI,ROA, are higher than expense method and CFI is lower
After construction time
CFO,NI,ROA are lower than expensed method and for CFI no change in either method?
 
AJ888: Yup, higher income leads to higher CFO. In the expansion phase, ROA is lower becuase your assets are bigger than usual by capitalizing interest. CFF is lower due to capitalized interest.
Level-1 december: Degree in Finance, Study CFA books, started a little early than usual, so answering this type of questions help me memorize what I have read. No special plan, I am going to finish CFA books and plan on buying schweser QBank only and start practicing and reviewing. For now, I am still reading the books.
 
ssdnola: i think theres a fundamental flaw in your reasoning. higher income does not always lead to higher cfo. in fact, in the case of inventory accounting, higher income translates to higher tax outlay and lower cfo. cfo in interest capitalization is higher because interest expense is reduced. the interest capitalized is recorded as an investment outflow (cfi).
 
Thats what i said, higher income becuase the firm is not expensing interest. And i was not talking about Inventory at all, it is a whole diffrent chapter and whole diffrent subject. So, yes i was referring to interest capitalization when i said higher income and higher net income than a firm that is expensing interest especially in the early years. In the late years, after the expansion, capitalized firm will have lower income and lower net income versus a firm that expense the whole interest due to the effect of amortizations.
 
ssdnola Wrote:
——————————————————-
> AJ888: Yup, higher income leads to higher CFO. In
> the expansion phase, ROA is lower becuase your
> assets are bigger than usual by capitalizing
> interest. CFF is lower due to capitalized
> interest.
> Level-1 december: Degree in Finance, Study CFA
> books, started a little early than usual, so
> answering this type of questions help me memorize
> what I have read. No special plan, I am going to
> finish CFA books and plan on buying schweser QBank
> only and start practicing and reviewing. For now,
> I am still reading the books.
and i quote “higher income leads to higher cfo”. thats misleading.
 
ssdnola Wrote:
——————————————————-
> AJ888: Yup, higher income leads to higher CFO. In
> the expansion phase, ROA is lower becuase your
> assets are bigger than usual by capitalizing
> interest. CFF is lower due to capitalized
> interest.
> Level-1 december: Degree in Finance, Study CFA
> books, started a little early than usual, so
> answering this type of questions help me memorize
> what I have read. No special plan, I am going to
> finish CFA books and plan on buying schweser QBank
> only and start practicing and reviewing. For now,
> I am still reading the books.
its not cff, its cfi. i assume its probably a typo.
 
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