What are imputed interest rates?

Equity capital is available to a company interest-free. If the money had been invested in the capital market, it would have earned interest. This fact is accounted for in accounting by a fictitious interest calculation, the so-called imputed interest.

Use of Imputed Interest

Imputed interest belongs to those cost types that are not included as expense in the income statement. Nonetheless, they are essential for internal company calculations. On one hand, imputed interest is used to determine the cost of goods or services and, based on this, cost-price analyses are performed. On the other hand, imputed interest increases the informative value of time, operational, and performance comparisons since it eliminates the interest burden of fluctuating external financing. Furthermore, imputed interest is also used to set the minimum return that an investment project must necessarily generate to be executed.

Calculation of Imputed Interest

The imputed interest rate depends on the company's total financing and can be calculated using the formula for the weighted average cost of capital (WACC):

The variables E and D stand for the market value of equity and debt, respectively. Together, they constitute the company value V. The variable kE represents the cost of equity (You can learn how to calculate the cost of equity in our article on Determining the Cost of Equity Using the CAPM). The interest on the debt is represented by the variable kD. The letter s stands for the uniform corporate tax rate. It is first subtracted from one, and the result is then multiplied with the cost of debt, as interest paid on debt is tax-deductible.

Example Application

XY AG has equity valued at 7 million francs and 3 million francs in bank debts on which it pays annual interest of 6%, while the cost of equity amounts to 12%. The company XY is taxed at a flat rate of 30%.

XY AG is now considering investing in a machine with which it will generate a surplus of 500,000 francs each year for 3 years. The machine costs 1,200,000 francs today. Whether the investment project is worthwhile for XY AG can now be calculated using the imputed interest. The revenues are discounted by the WACC.

Since the net present value is positive, the investment project would be financially beneficial for XY AG.

• Further Information
   
• Offer for Trust Accounting