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Question
On 1 January 20X6 Stremans Co borrowed $1.5m to finance the production of two assets, both of which
were expected to take a year to build. Work started during 20X6. The loan facility was drawn down and
incurred on 1 January 20X6, and was utilised as follows, with the remaining funds invested temporarily.
Asset A Asset B
$’000 $’000
1 January 20X6 250 500
1 July 20X6 250 500
The loan rate was 9% and Stremans Co can invest surplus funds at 7%.
Required
Ignoring compound interest, calculate the borrowing costs which may be capitalised for each of the assets
and consequently the cost of each asset as at 31 December 20X6I dont understand why less investment income in answer of the question?? Can you explain it for me ? Thanks in advance
The answer is
Asset A Asset B
$ $
Borrowing costs
To 31 December 20X6 $500,000/$1,000,000 x 9% 45,000 90,000
Less investment income
To 30 June 20X6 $250,000/$500,000 x 7% x 6/12 (8,750) (17,500)
36,250 72,500
Cost of assets
Expenditure incurred 500,000 1,000,000
Borrowing costs 36,250 72,500
536,250 1,072,500Hi,
We have borrowed in total $1.5m @ 9% at the start of the year but this is not used in full immediately. When it is not being used to fund the construction of the asset it is invested, and whilst it is invested we will received interest. The interest received is then net against the interest expense, and the net expense is capitalised.
So if we use asset A, then we use $0.5m of the funds to construct this asset, on which interest at 9% will be charged and capitalised as part of the cost of the asset.
The key to understanding the investment income aspect is to look at when the $0.5m is spent. Half of it is spent on 1 January, and so the other half is invested until 1 July at 7%. So we will receive interest on $0.25m at 7% for six months, hence the $8,750 figure in the answer.
The $8,750 is then net against the interest expense of $45,000 to give the net borrowing costs capitalised at $36,250.
I hope this clears it up, try it for asset B and see if you understand it better.
Thanks
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