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**CFA Practice Question**

A company constructed an asset for $3,500,000, financed entirely with debt at 6% interest. It took six months to construct the asset and the firm has a 1:1 optimal debt equity ratio with a tax rate of 34%. Which of the following statements regarding cash flows is TRUE, if the company capitalizes construction interest? In order to remove distortion, ______

A. an analyst should increase CFO by $69,300 and reduce CFI by $34,650.

B. an analyst should increase CFI by $210,000 and reduce CFO by $210,000.

C. an analyst should increase CFI by $105,000 and reduce CFO by $105,000.

**Explanation:**Capitalized interest for six months = 3,500,000 x 0.06 x 0.5 = 105,000. Since the interest is capitalized, there are no tax effects. Optimal capital structure is ignored as we are dealing with actuals.

The analyst needs to reverse the capitalized interest out of CFI by adding it back, and subtracting it from CFO. Net income would have to be reduced by 69,300 = 105,000 - 35,700 (= 105,000 x 0.34). (Net income is not mentioned in the question.)

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**User Contributed Comments**
6

User |
Comment |
---|---|

danlan |
Since capitalizing interest decreases CFI and increases CFO, the analyst should do the reverse: increase CFI and reduce CFO. The amount is the interest amount. |

chuong |
instead of charging to expense (CFO), we switch to additional investment (CFI) -> (+) to CFI and (-) from CFO. If interest is capitalised -> expenses reduce -> net income increase = (1-T)x capitalised interest |

steved333 |
six months!!! |

meghan |
finanaced assets x interest x .5(for semi annual!!!)adding into CFI and out of CFO |

mrpman |
If the interest was not capitalized then what would be the tax implications? |

sresis |
Could A be eliminated simply because the adjustments to CFO and CFI are not equal? |