In schweser, it mentions that interest coverage ratio will be higher for the initial yr when interest fee is capitalized vs expensed and it will be lower in the future years. The reason is due to higher depreciation, and therefore lower EBIT for the future years. I think that the interest coverage ratio will always be lower when the interest fee is expensed due to higher interest value in EBIT/Interest Expense. Can someone correct me? Thx.
Well the first year, Interest expense is higher under expensing for the first year so the interest coverage ratio is lower. However, the following years, there would no interest expense for the expensing firm so the interest coverage ratio for the company in the later years would be higher due to lower interest expense. This is how I think of it anyway…
yes it is
My source of confusion is this. I don’t think it is the right assumption to assume that interest expense is only for the first year. The interest fee should be expensed as incurred (matching principle), therefore, I am assuming that it will be expensed for many periods.
but remember the interest expense that would have been recognized on the income statement has been capitalized - now it is an asset. So interest expense would not be as much as before.
But that is not the point. We are arguing whether the interest expense would be higher for companies that expense it or companies that capitilize it. My argument is that it would always be higher for companies that expense it; not only in the first year since interest is expensed when accrued.
It is not Companies that expense or Companies that Capitalize. There is a distinction between that - and the statement - between a company that was expensing vs. is now capitalizing. Most of the FRA stuff in both Level 1 and 2 are discussing two sides of the same coin. One when the company expensed - vs. now when it is capitalizing. Compare ratios. Look at the same problem in a different way: Company A had 100K of Interest expense. Compare the Interest Coverage ratio if the 100K were expensed as originally vs. if the company had chosen to capitalize the 100K of interest expense. What would be the impact in the year of conversion? What would be the impact going forward… What happens to a company that had a Capitalized lease - vs. the same company, same lease - but an operating lease? What happens to a company that issues a Par bond - vs. same company, same bond - but is a premum bond… what are the effect on the ratios, interest expense, etc. etc. So look at it that way in most of FRA. Even your statement - depends on the state of the companies, where it is in their life cycles - and then the big question becomes - are you comparing apples to apples…
Thanks for the reply. I think I understand the point.