Welcome to Wall Street Prep! Use code at checkout for 15% off.
Wall Street Prep

Deal Accounting Interview Question

Learn Online Now

Deal Accounting Interview 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.

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.

Step-by-Step Online Course

The Investment Banking Interview Guide ("The Red Book")

1,000 interview questions & answers. Brought to you by the company that works directly with the world’s top investment banks and PE firms.

Enroll Today
most voted
newest oldest
Inline Feedbacks
View all comments
Archana Subash
Archana Subash
August 31, 2018 5:51 am

Awesome examples….request more mutual fund transactions accounting treatments

Adam Still
Adam Still
July 20, 2018 9:36 am

I know the question says straight line depreciation but I know the IRS doesn’t allow you to use straight line when writing off depreciation expense, they make you use MACRS. A lot of the accounting IB questions talk about the tax benefit of depreciation, but always default to using the… Read more »

Haseeb Chowdhry
Haseeb Chowdhry
October 18, 2018 5:20 pm
Reply to  Adam Still

Hi Adam, The trick with different depreciation methods is to understand their underlying implications, particularly with regards to taxes. For instance, if you use an accelerated depreciation schedule for cash tax purposes, you will have a lower cash tax expense in earlier years. At the same time, if GAAP tax… Read more »


The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.