CFA Practice Question

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CFA Practice Question

Ashley Corporation constructed an office building for its own use. During 2015, the average accumulated expenditure for construction was $4,000,000. At the end of 2014, Ashley had borrowed $1,000,000 specifically for the construction costs. The interest on the construction loan was 11%. The only other debt was $10,000,000 debentures (outstanding all of 2015), with an interest rate of 8%. What are the amounts of interest to be capitalized and expensed in 2015?
A. $440,000 and $110,000
B. $350,000 and $560,000
C. $110,000 and $800,000
Explanation: The amount of interest to be capitalized cannot exceed the appropriate interest rates multiplied by the average accumulated expenditures for construction. It is to be applied first using any specific borrowing amounts. The interest capitalized would be ($1,000,000 x .11) + ($3,000,000 x .08) = $110,000 + $240,000 = $350,000. The amount to be expensed would be the remainder of the total interest ($910,000), which is $560,000.

User Contributed Comments 19

User Comment
kalps Ok, the interest on 350K being capitalised is assuming that the debentures are being used to partly pay for the project. Hence there are two elements of financing: 1: The specific loan we are told 2: The debenture of which we have to assume that part of it is specific i.e. the remained 3m
humphrey this question is nonsense, how can we assume the project is all debt financed?
gjwhite The solution provided is correct, refer to page 328 in White, Sondhi and Fried.
Bira yeah, solution is correct. Debt is not necessary related to the project, and still its interest must be capitalized.
armanaziz According to US GAAP the answer is correct, but isn't the last one correct according to IAS? Question should clarify which one to follow!
danlan By default, you follow US GAAP
gene80 how did you get 910,000 as total interest?
BenC $1,000,000*11% + $10,000,000*8%=$910,000
CoffeeGirl total cost of the construction = 4M
Borrowed 1M at 11%.
Remaining is 3M at 8%.
so, total capitalized interest = 1M x 0.11 + 3M x 8% = 0.35M ( capitalized interest )

Total interest = 1M X 0.11 + 10M x 0.8 = 0.91
0.91 - 0.35 = 0.65 (expensed interest)
CoffeeGirl so, total interest = expensed interest + capitalized interest
Xocrevilo CoffeGirl: 0.56, not 0.65
Kuki should we just assume that the entire project is financed using debt???
daddyS9107 The CFA book clearly says "borrowing costs directly incurred DIRECTLY related to the construction are generally capitalized" and furthermore: "If a company takes out a loan specifically to construct the building, the interest cost on that loan during the time of construction would be capitalized...". So the answer is very wrong because it doesn't seem that the 10M debenture is used specifically for the construction.
kjproehl5 This is what I call a 33 percenter
adidas @daddyS9107: read the question. Not all 10 million was used in construction. You cannot capitalize those you did not spend on construction.
daverco @adidas. What daddyS9107 refers to is that the question doesn't specify whether the remainder ($3M) of the project is financed by 'regular' debt outstanding. We seem to have to assume it (which is not entirely unreasonable, because it has to come from somewhere, but I don't think an exam question would be phrased this unclearly). Why couldn't we assume the $3M was financed with equity for example, rendering C a viable answer?
dbalakos I can totally imagine such a question on the exam requiring C as the correct answer XD
kingirm looks more like a level II question. spesific knowledge.
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