fm14 14 - if debt is added throughout the year instead of...

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Mini Case: 14 - 14 Interest expense is actually based on the daily balance of debt during the year. There are three ways to approximate interest expense. You can base it on: (1) debt at end of year, (2) debt at beginning of year, or (3) average of beginning and ending debt. Basing interest expense on debt at end of year will over-estimate interest expense if debt is added throughout the year instead of all on January 1. It also causes circularity called financial feedback: more debt causes more interest, which reduces net income, which reduces retained earnings, which causes more debt, etc. Basing interest expense on debt at beginning of year will under-estimate interest expense
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Unformatted text preview: if debt is added throughout the year instead of all on December 31. But it doesn’t cause problem of circularity. Basing interest expense on average of beginning and ending debt will accurately estimate the interest payments if debt is added smoothly throughout the year. But it has the problem of circularity. A solution that balances accuracy and complexity is to base interest expense on beginning debt, but use a slightly higher interest rate. This is easy to implement and is reasonably accurate. See FM12 Ch 14 Mini Case Feedback.xls for an example basing interest expense on average debt....
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