Question

Week 7 Pre-Assignment Part 1 Interest Capitalization • The concept is that if you had an asset constructed and paid for it upon completion, the cost would include interest. Thus, interest a company incurs during construction can be added to the cost of the asset. Interest that would have otherwise been an expense of the period is rolled into the cost of the asset. Building the "base" to which interest is applied: • Interest is applied to cost of land during construction period. Application starts the day construction starts and end on date of completion • Interest is applied to construction expenditures during construction period from date of expenditure to date of completion Land and expenditures are "annualized". For example, $600,000 spent on June 1 and where project is completed October 1 would be $600,000 X 4/12 - $200,000, Applying Interest: • Loans are also annualized. A $200,000 loan that starts on April 1 and is paid off on October 1 at 6%. Would be $200,000 X 6/12 -$100,000. The interest would be $100,000 X 6% - $6,000. • Interest is first applied on construction loans at the applicable rate. The limit on interest capitalized is the "base" (the annualized expenditures on asset) If there is remaining base, interest is applied at the weighted average interest rate on all other debt during the period. Again, the limit is the "base". Try working the following example: Assume Construction started on March 1, 2016 and was completed on Oct. 1, 2016 First, build the "base" based on the following expenditures during 2016: Completion Amount expenditure Jan 1 June 1 Oct 1 date Oct 1 Oct 1 Oct 1 Land Expenditure 1 Expenditure 2 $240,000 840,000 400,000 Second, apply interest to the base, construction interest first. Here are the loans: Rate Start date 6/1/2016 10/1/2015 Date repaid 11/1/2016 10/1/2017 Loan Construction General 10% 8% Amount $550.000 1,000,000

Answer 1

Date	Expenditures incurred	Cost of construction
1/1/2016	Land	$240,000
1/6/2016	Exps 1	$840,000
1/10/2016	Exps 2	$400,000
		$1,480,000
1/10/2016	Interest on Loan Capitalised	$18,333
(10% on 550,0000 for 4 months (June'16 to Sep'16)
1/10/2016	Interest on Loan Capitalised
(8% on 1,000,0000 for 13 months (2015 oct to 2016 Sep)	$80,000
	Total cost of the asset	$1,578,333

Interest on construction loan for 2 months from Oct'16 to Nov'16 will be charged to P&L as expense

it is assumed general loan is used towards constrcution and the interest from Oct'16 to Oct'17 will be charged to P&L as expense