In order to calculate the interest expense during year two we have to start with the debt at the end of year one. Let's now add in the debt at the end of year two as well. Let's assume the year one debt was 100 and the year two debt was 50. The question is, what do we pay interest on? Do we pay interest on the year one figure? The 100 i.e. the amount you started year two with. Or would you pay interest on the amount you ended year two with, the 50? Well, clearly what's happened during the year is that we've gone from 100 of debt down to 50. We've paid off 50, but we don't know when that happened. Technically, you should pay interest on the 100 for when you had 100 of debt and you should pay interest on the other 50 for the remainder of the year. But we don't know when the 50 was repaid. So all we know is that we started with 100 and ended with 50. The rule that we're going to use is that we'll take the average debt balance during the year. The average of 100 plus 50 divided by two is 75, so my average debt balance is 75. We can then multiply that by the interest rate and that will give me the interest expense during year two. So just to clarify, this is interest expense using average debt balances.