Interest calculations.

Let's think about how we can calculate the interest expense for year two. When companies pay interest on their debt balances throughout the year, usually this is calculated on a daily basis. So interest expense isn't just based on a debt balance at the start of the year or at the end of the year. We need to make sure that our interest calculation is a good approximation of how much interest the company will actually pay. Let's assume that the year one debt was 100 and the year two debt was 50. The company must have paid off 50 of its debt during the year. Even though we don't know when that repayment was made, we do know that the company will have been paying interest on a debt balance of 100 for some of the year and a debt balance of 50 for some of the year. So if we were to calculate interest just using the year one balance, the interest expense would be too high, and if we were to calculate interest expense just using the year two balance, the interest expense would be too low. The simple way to deal with this is to calculate interest using the average debt balance during the year. The average of 150 is 75, so I could take the average debt balance of 75 and multiply that by the interest rate on the debt and that would give me the interest expense for year two.