CFA Level I · CFA Level I Exam · Financial Statement Forecasting in Equity Valuation
An analyst forecasts that a retailer will fund growth by issuing new debt each year. When projecting interest expense, which method is most appropriate to avoid a circular reference while remaining reasonable?
Applying the interest rate to the beginning-of-period debt balance is most appropriate. It avoids a circular reference, because interest no longer depends on the current-year borrowing that itself depends on net income, and it still recognizes the cost of existing debt.
- AApply the interest rate to the beginning-of-period debt balanceCorrect
- BAssume interest expense is zero in forecast years
- CApply the interest rate to the ending debt balance that depends on net income
Explanation
Using beginning balance avoids circularity because interest then does not depend on current-year financing needs driven by net income. Ending balances create circularity; zero interest is unrealistic.
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