If I issue $100mm of debt and use that to buy new machinery for $50mm, walk me through what happens in the financial statements when the company first buys the machinery and in year 1. Assume 5% annual interest rate on debt, no principal pay down for the 1st year, straight-line depreciation, useful life of 5 years, and no residual value.
Sample Great Answer
If the company issues $100mm of debt, assets (cash) goes up by $100mm and liabilities (debt) goes up by $100mm. Since the company is using some of the proceeds to buy machinery, there is actually a second transaction that will not affect the total amount of assets. $50mm of cash will be used to buy $50mm of PPE; thus, we are using one asset to buy another one. This is what happens when the company first buys the machinery.
Because we have issued $100mm of debt, which is a contractual obligation, and because we are not paying down any part of the principal, we must pay interest expense on the entire $100mm. So, in year 1 we must record corresponding interest expense which is the interest rate times the principal balance. Interest expense for the 1st year is $5mm ($100mm * 5%). And, since we now have $50mm of new machinery, we must record depreciation expense (as required by matching principle) for use of the machinery.
Since the problem specifies straight-line depreciation, useful life of 5 years, and no residual value, depreciation expense is $10mm (50/5). Both interest expense and depreciation expense provide tax shields of $5mm and $10mm, respectively, and will ultimately reduce the amount of taxable income.Read More From: IB Interview Tips