CFA Level 1: CFA Level 1 Exam Question

Quasar, Inc. - Interest Expense and Tax Implications

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Question

Quasar, Inc., currently shows assets worth 5,000 and a debt of 1,500. During the year, it capitalized interest expense worth 300, of which 60 was amortized.

Quasar's tax rate is 50%. If it had expensed the interest paid, which of the following would be true?

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A. B. C. D.

A

If Quasar had expensed the interest, its tax savings would have been 300*50% = 150. By capitalizing, it amortized 60, leading to a tax savings of 60*50%=30.

Thus, if it had expensed the interest, the tax expense would have been lower by 150-30=120 (What would the effect on net income be? The net income would be lower by (300 - 60 - 120 = 120). When capitalizing, all the expense gets charged to investing cash flow while expensing charges the entire cash flow to operating cash flow. After tax, this results in an operating cash flow of -300*(1-0.5) = -150. Thus, expensing would have resulted in an operating cash flow lower by 150.

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