To meet the increasing demand for its microprocessors, Intelligent Micro Devices began construction of a new manufacturing facility on January 1, 2014. Construction costs were incurred uniformly throughout 2014 and were recorded in the firm’s Construction-in-progress account.
The average balance in the Construction-in-progress account during 2014 was $150 million. To facilitate the facility’s construction, the firm arranged for an $80 million construction loan on January 1 at a rate of 13%. The firm also issued $40 million of common stock to help finance the project. Management estimates that the firm’s cost of equity capital is 16%. On January 1, 2014, the firm also issued bonds in the amount of $200 million carrying a weighted-Average interest rate of 11.5%. Earnings before interest and taxes for 2014 is $50 million.
1. What is the total amount of interest the firm incurred in 2014?
2. Assume that the firm bases the amount of capitalized interest on the average balance in the Construction-in-progress account. How much of the interest in requirement 1 should be capitalized?
3. How much of the amount in requirement 2 will be related to the firm’s common stock issue? Why?
4. Where will the amount in requirement 2 appear in the firm’s 2014 financial statements?
5. What amount of interest expense will appear in the firm’s 2014 income statement?
6. Assume that the facility is completed on December 31, 2014, and that it is placed in service on January 1, 2015. How, if at all, will the amount in requirement 2 affect the future income of the firm?
7. Calculate the firm’s interest coverage ratio (income before interest and taxes divided by interest expense) with and without the interest capitalization. Which coverage ratio would be more useful to a creditor in the evaluation of the firm’s risk of insolvency?