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# Investment Banking Interview Question: “Walk me through the accounting for the following transaction”

April 4th, 2012| Written By The Wall Street Prep Team 2 Comments

Note: This question is part of our series on investment banking interview questions. For this question, you’ll need basic accounting knowledge.

#### Question:

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.

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.

Written by The Wall Street Prep Team

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## 2 Responses

1. October 30, 2014

What is the impact on the Statement of Cash Flows. Everywhere I see, they include CAPEX as part of the CFI, but if the CAPEX is funded with debt, that doesn’t really make sense to me…

• October 30, 2014

On the cash flow statement, you will reflect the following line items: new \$10m depreciation stemming from new equipment (under CFO), capital expenditures (under CFI) as you used \$50m cash to purchase that equipment; and finally, a \$100m increase in debt (under CFF) stemming from debt issuance.

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