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Interest Capitalization Example(adopted from textbook)
1) First, identify when and how much the firm paidfor actual building expenditures during the year
Interest Capitalization Example
1) First, identify when and how much the firm paidfor actual building expenditures during the year
Jan 1: $210,000Mar 1: 300,000May 1: 540,000Dec 31: 450,000
Interest Capitalization Example
2) Second, compute weighted-average funding needs to make these expenditures
Jan 1: $210,000Mar 1: 300,000May 1: 540,000Dec 31: 450,000
Interest Capitalization Example
2) Second, compute weighted-average funding needs to make these expenditures
This method assumes the firm borrows $210,000 for the full year then $300,000 for 10 months of the year then $540,000 for 8 months of the year, in order to make this payment schedule.
Jan 1: $210,000Mar 1: 300,000May 1: 540,000Dec 31: 450,000
Interest Capitalization Example
2) Second, compute weighted-average funding needs to make these expenditures
Note that this method also assumes that the firm borrows $450,000 on the last day of the year. This will not accrue interest during this particular year, so we will ignore it.
Interest Capitalization Example
2) Second, compute weighted-average funding needs to make these expenditures
Date Amount Interest Accrual period
Weighted-Average
Funding Needs
Jan 1 $210,000
Mar 1 300,000
May 1 540,000
Dec 31 450,000
Total
Interest Capitalization Example
2) Second, compute weighted-average funding needs to make these expenditures
Date Amount Interest Accrual period
Weighted-Average
Funding Needs
Jan 1 $210,000 12 mos./12 mos.
Mar 1 300,000
May 1 540,000
Dec 31 450,000
Total
Interest Capitalization Example
2) Second, compute weighted-average funding needs to make these expenditures
Date Amount Interest Accrual period
Weighted-Average
Funding Needs
Jan 1 $210,000 12/12 $210,000
Mar 1 300,000
May 1 540,000
Dec 31 450,000
Total
Interest Capitalization Example
2) Second, compute weighted-average funding needs to make these expenditures
Date Amount Interest Accrual period
Weighted-Average
Funding Needs
Jan 1 $210,000 12/12 $210,000
Mar 1 300,000 10/12 250,000
May 1 540,000
Dec 31 450,000
Total
Interest Capitalization Example
2) Second, compute weighted-average funding needs to make these expenditures
Date Amount Interest Accrual period
Weighted-Average
Funding Needs
Jan 1 $210,000 12/12 $210,000
Mar 1 300,000 10/12 250,000
May 1 540,000 8/12 360,000
Dec 31 450,000
Total
Interest Capitalization Example
2) Second, compute weighted-average funding needs to make these expenditures
Date Amount Interest Accrual period
Weighted-Average
Funding Needs
Jan 1 $210,000 12/12 $210,000
Mar 1 300,000 10/12 250,000
May 1 540,000 8/12 360,000
Dec 31 450,000 0/12 0
Total
Interest Capitalization Example
2) Second, compute weighted-average funding needs to make these expenditures
Date Amount Interest Accrual period
Weighted-Average
Funding Needs
Jan 1 $210,000 12/12 $210,000
Mar 1 300,000 10/12 250,000
May 1 540,000 8/12 360,000
Dec 31 450,000 0/12 0
Total 820,000
This represents the average amount of funding (borrowing) the company had to pay interest on, during the year, for the ongoing project.
Interest Capitalization Example
3) Third, map company’s existing debt to the amount of weighted average funding needs you just computed
Interest Capitalization Example
3) Third, map company’s existing debt to the amount of weighted average funding needs you just computed
December 31 debt outstanding:
• 15%, 3 year note to finance construction $750,000• 10%, 5 year note $550,000• 12%, 10 year bonds $600,000
Total funds available from debt $1,900,000
Interest Capitalization Example
3) Third, map company’s existing debt to the amount of weighted average funding needs you just computed
December 31 debt outstanding:
• 15%, 3 year note to finance construction $750,000• 10%, 5 year note $550,000• 12%, 10 year bonds $600,000
Construction funding needs = $820,000 (computed earlier)
Interest Capitalization Example
3) Third, map company’s existing debt to the amount of weighted average funding needs you just computed
December 31 debt outstanding:
• 15%, 3 year note to finance construction $750,000• 10%, 5 year note $550,000• 12%, 10 year bonds $600,000
Construction funding needs = $820,000 (computed earlier)
• $750,000 from 15% construction note
Interest Capitalization Example
3) Third, map company’s existing debt to the amount of weighted average funding needs you just computed
December 31 debt outstanding:
• 15%, 3 year note to finance construction $750,000• 10%, 5 year note $550,000• 12%, 10 year bonds $600,000
Construction funding needs = $820,000 (computed earlier)
• $750,000 from construction note• $70,000 remaining from both 10% note and 12% bonds
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
$70,000 10% Note
12% Bonds
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15%
$70,000 10% Note
12% Bonds
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15%
$70,000 10% Note
12% Bonds
Weighted Average
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15%
$70,000 10% Note
12% Bonds
Weighted Average:
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15%
$70,000 10% Note
12% Bonds
Weighted Average: Debt Type Principal Interest
10% Note $550,000
12% Bonds
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15%
$70,000 10% Note
12% Bonds
Weighted Average: Debt Type Principal Interest
10% Note $550,000 $55,000
12% Bonds
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15%
$70,000 10% Note
12% Bonds
Weighted Average: Debt Type Principal Interest
10% Note $550,000 $55,000
12% Bonds $600,000
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15%
$70,000 10% Note
12% Bonds
Weighted Average: Debt Type Principal Interest
10% Note $550,000 $55,000
12% Bonds $600,000 $72,000
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15%
$70,000 10% Note
12% Bonds
Weighted Average: Debt Type Principal Interest
10% Note $550,000 $55,000
12% Bonds $600,000 $72,000
Totals $1,150,000 $127,000
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15%
$70,000 10% Note
12% Bonds
Weighted Average: Debt Type Principal Interest
10% Note $550,000 $55,000
12% Bonds $600,000 $72,000
Totals $1,150,000 $127,000
127,0001,150,000
= 11.04%
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15%
$70,000 10% Note
12% Bonds
11.04%
Weighted Average:
127,0001,150,000
= 11.04%
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15% 112,500
$70,000 10% Note
12% Bonds
11.04% 7,728
Total $120,228
Interest Capitalization Example
4) Fourth, compute interest accrued for funding needs
Construction funding needs = $820,000 (computed earlier)
Amount Source Interest Rate for Source
Interest Accrued
$750,000 15% Construction Note
15% 112,500
$70,000 10% Note
12% Bonds
11.04% 7,728
Total $120,228
This is “avoidable” interest.
Interest Capitalization Example
5) Fifth, capitalize lesser of total interest paid by firm and “avoidable” interest
Interest Capitalization Example
5) Fifth, capitalize lesser of total interest paid by firm and “avoidable” interest
• Avoidable interest $120,228• Total interest paid:
Interest Capitalization Example
5) Fifth, capitalize lesser of total interest paid by firm and “avoidable” interest
• Avoidable interest $120,228• Total interest paid:
15% Construction Note
750,000 x 0.15 112,500
10% Note 550,000 x 0.10 55,000
12% Bonds 600,000 x 0.12 72,000
Total $239,500
Interest Capitalization Example
5) Fifth, capitalize lesser of total interest paid by firm and “avoidable” interest
• Avoidable interest $120,228• Total interest paid: $239,500
