REPORT ON CAUSES AND EFFECTS OF

INTEREST CAPITALIZATION /
AMORTIZATION ON PROJECTS UNDER
IMPLEMENTATION AND AT OPERATIONAL
STAGES

Prepared by:

Gizachew Nadew………Research Officer

Garoma Chali………….. Research Officer

Research and Project Data Management

Directorate of Development Bank of
Ethiopia

March, 2021

STATEMENT OF APPROVAL

This report entitled “CAUSES AND EFFECTS OF INTEREST CAPITALIZATION /

AMORTIZATION ON PROJECTS UNDER IMPLEMENTATION AND AT
OPERATIONAL STAGES” has been approved by the Director and Research
A/Deputy Director of the Directorate after the research deputy director has made a
thorough review of the report.

__________________________ ______________________________

Tsegaye Hubena Date

(A/Deputy Director)

__________________________ ______________________________

Hunegnaw Zegeye Date

(Director)

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TABLE OF CONTENTS

STATEMENT OF APPROVAL..........................................................................................................ii

LIST OF TABLES................................................................................................................................vi

LIST OF FIGURES.............................................................................................................................vii

ACRONYMS.....................................................................................................................................viii

EXECUTIVE SUMMARY..................................................................................................................ix

1. INTRODUCTION.....................................................................................................................1

1.1. Background of the Study...................................................................................................1

1.2. Statement of the Problem...................................................................................................3

1.3. Research Questions.............................................................................................................4

1.4. Objectives of the Study.......................................................................................................4

1.5. Scope of the Study..............................................................................................................5

1.6. Limitation of the Study......................................................................................................5

1.7. Significance of the Study....................................................................................................5

1.8. Organization of the Study..................................................................................................5

2. LITERATURE REVIEW.............................................................................................................7

2.1. Loan Restructuring.............................................................................................................7

2.1.1. Interest Capitalization/Amortization......................................................................7

2.1.2. Other Relief Measures..............................................................................................11

2.2. Factors that affect Loan repayment of Financed Projects.............................................16

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3. METHODOLOGY.....................................................................................................................18

3.1. Research Design................................................................................................................18

3.2. Instruments of Data Collection.......................................................................................18

3.3. Population and Sample Selection....................................................................................18

3.4. Method of Data Analysis.................................................................................................21

4. DATA ANALYSIS AND DISCUSSION.................................................................................22

4.1. Interest Capitalization and Amortization Trends in DBE............................................22

4.1.1. Interest Capitalization among Working Units......................................................24

4.1.2. Interest Amortization...............................................................................................25

4.1.3. Interest Amortization across Working Units.........................................................26

4.1.4. Interest Amortization and capitalization across Economic Sectors....................28

4.1.5. Loan status/classification of the project at the time of Interest capitalization

and Amortization......................................................................................................................28

4.2. Descriptive Statistics on the Cause and Effect of Interest Capitalization and
Amortization.................................................................................................................................29

4.2.1. Cost Related Factors.................................................................................................29

4.2.2. Revenue Related Factors..........................................................................................30

4.2.3. Other Factors.............................................................................................................32

4.3. Issues Raised on Open Ended Questions Related to the Possible Cause of Interest
Capitalization and Amortization................................................................................................33

4.5. Effect of Interest Capitalization and Amortization.......................................................37

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 4.6. What if Interest Capitalization and Amortization was not made?.............................38

5. CONCLUSION AND RECOMMENDATION......................................................................40

5.1. Conclusion.........................................................................................................................40

5.2. Recommendation..............................................................................................................42

6. REFERENCES............................................................................................................................43

7. Appendix...................................................................................................................................44

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 LIST OF TABLES

Table 3-1: Sample projects for the study in each working units.................................................19

Table 4-1: Interest capitalization across DBE working units.......................................................25

Table 4-2: Interest amortization trend in DBE...............................................................................26

Table 4-3: Interest Amortization across working units................................................................27

Table 4-4: Number of project under interest amortization and capitalization and number of
actions................................................................................................................................................27

Table 4-5: Respondents’ idea on the possible causes of interest capitalization and
amortization......................................................................................................................................33

Table 4-6: Respondents Degree of agreement on adherence to the general principle of

restructuring in the time of interest capitalization and amortization........................................36

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 LIST OF FIGURES

Figure 4-1: Amount of interest capitalized and total amount of loan under interest
capitalization in DBE............................................................................................................22

Figure 4-2: Amount of interest capitalized under implementation stage and

operational stage...................................................................................................................23

Figure 4-3 Number of project under interest capitalization (2014-2020)......................24

Figure 4-4: Interest capitalization and amortization across economic sectors.............28

Figure 4-5: Loan status of the project at the time of interest capitalization and
amortization...........................................................................................................................29

Figure 4-6: Cost related causes for interest capitalization and amortization in DBE..29

Figure 4-7: Revenue related causes for interest capitalization and amortization in
DBE..........................................................................................................................................31

Figure 4-8: Other factors that causes for interest capitalization and amortization in
DBE..........................................................................................................................................32

Figure 4-9: Respondents’ idea on the effect of interest capitalization and amortization
..................................................................................................................................................37

Figure 4-10: Respondents idea on the final consequence of limiting interest

capitalization and amortization..........................................................................................38

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 ACRONYMS
CRMD…………..Customer Relationship Management Directorate
DBE……………..Development Bank of Ethiopia
GAAP…………...Generally Accepted Accounting Principles
IAS………………International Accounting Standards
NPLs…………....Non-performing Loans
NPV…………….Net Present Value
PRLRD…………Project Rehabilitation and Loan Recovery Directorate
USA……………..United States of America

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 EXECUTIVE SUMMARY

DBE has introduced loan restructuring and rescheduling technique to manage and
rehabilitate sick projects; where capitalized interest on loans is uncollected interest
which is added to unpaid principal in accordance with the contractual loan agreement. In
line with this, the amount of interest capitalization and amortization in DBE is
increasing from time to time. This may rise from different causes.

Hence, this particular study was aimed to assess the causes and effects of interest
capitalization and amortization on DBE financed projects.

To achieve the objectives of the study, data was collected from projects that are
under the categories of interest capitalization and amortization in the time period
from 2011 - 2020. For primary data, the researchers used structured questionnaire
and the questionnaire was dispatched to the credit staffs both at head office and
district to identify the major causes of interest capitalization and amortization
through the Google form platform. Then the data collected from different sources
were coded, checked and entered to simple Microsoft excel program to make the
data ready for analysis and for descriptive analysis; table and percentage were used
to analyze the data.

Result of the study revealed that between the time periods 2014- 2020 a total amount
of Birr 1,532,131,533.86 and 972,679,754.118 interest capitalized and amortized,
respectively. The trend of DBE interest capitalization and amortization indicates
that, it is rising year to year. Amount of interest capitalization is high at operational
stage of the project while amount interest amortization is high at implementation
stage of the project. The finding of the study also indicates that the largest portion of
capitalized interest in DBE is occupied by CRMD IV and II, which alone encompass
67.5% of the total interest capitalized in DBE. The same working unit (CRMD IV)
alone also took 55.2% of the total interest amortized in DBE. This tell us the existence

ix
of troubled project in those working units which need special attention, since it has
final impact of the financial performance and loan status of the bank. The finding of
the study also shows that among the total number of project in which their interest
amortized and capitalized the largest proportion (59%) is occupied by agricultural
sector and followed by manufacturing sector, which is 26%. The data also indicates
that 33% of the projects interest capitalized and amortized at doubtful, 23% at
substandard, 21% of project at pass, 12% of the project at special mention and 11% at
loss status.

Besides, according to the data obtained from the contact officer of the projects
through structured questionnaire cost related factors unit costs (46.2%) was the major
factor for the interest capitalization and amortization in DBE followed by fluctuation
of personnel; whereas among revenue related factors for interest capitalization and
amortization in DBE decline income from sales was the major cause (41.1%) followed
by loss of market share problem (23.4%). Along with these factors political instability
(27.2%), project implementation delay (25.4%), natural catastrophes (16.0%),
temporary management problem (12.4%), raw material and other supplies shortage
in the market (11.2%), and design change (7.7%) also led for interest capitalization
and amortization in DBE.

Furthermore, of the issues indicated by the respondents on the open ended question
for the cause of interest amortization and capitalization political instability and
security problem, harsh weather condition, heavy rainfall and windstorm, project
implementation delay and pests and insects were the major one. Causes like electric
power shortage and interruption, shortage of raw material and raw material price
escalation and market problem, failure to include all the necessary investment items
at project appraisal and disbursements, foreign currency problem, cost overrun on
different investment items, lack of accessories for machines, high maintenance and
repair cost were also relatively raised as possible cause of interest capitalization and
amortization in DBE.

Lastly, the finding of the study also indicates that making interest amortization and
capitalization has both positive side and negative side effect. Among the positive

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side helping the project to get financial relief and sustained its business operation,
project implementation finalized and improving loan status of the project were
mentioned. Whereas the negative side effect mentioned by the respondents were
increase debt burden on the borrowers, the collateral coverage and equity
contribution decline and encourage wilful defaulters.

Based on the findings of the study, the study team has drawn the following
recommendations;

 Interest restructuring request of the client should be accepted if credit

processing unit and the bank management ensure that the project cash flow is
well previously and problem faced the project is temporary.
 The bank should only consider interest restructuring (interest capitalization and
amortization) for clients who have good repayment history.
 Interest restructuring of the bank should only consider for projects in which
their loan status/ classification is either pass or special mention, since making
the interest restructuring for projects under substandard, doubtful and loss
status might affect the loan recovery of the bank.
 The credit processing unit should work to shorten project implementation so as
to enable the project to generate income within the intended time.
 The interest capitalization should consider debt equity ratio and should ensure
the capitalized interest is covered with adequate collateral
 To minimize interest arrears restructuring in the long run (either in
capitalization form or amortization from) the bank should make adequate
feasibility study to ensure the project is profitable and has adequate market
access.
 Bank restructuring should not be done in order to conceal inefficient loans
gathered in portfolios.
 The bank should generally avoid offering interest capitalization and
amortization more than once and the interest capitalization should only be
applied to arrears that do not exceed a predefined size relative to the overall
principal.

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1. INTRODUCTION
1.1. Background of the Study

The prime motto of banks is to maximize profit through its diverse credit activities in
line with faster economic growth. It is important to mention that loans and advances
constitute the most significant portion of aggregate assets of the banking industry.
The major portion of bank’s earnings comes from interest income levied on credit
activities (commonly known as loans and advances). Thus, banks need to take most
vital decision to extend loans by absorbing calculated risks. Therefore, banks who
can measure and manage risks effectively, can maintain good portfolio and those
who do not, experience stuck-up portfolio and eventually turn out to bad over a
period of time. In the project finance loan repayment is among the credit risks. To
minimize consequent credit risks in the time of difficulty many banks have used
some relief measures like interest arrears capitalization and amortization.

Capitalized interest on loans is generally defined as uncollected interest which is

added to unpaid principal in accordance with the contractual loan agreement. The
lender may capitalize interest costs at the end of a deferment or forbearance. Because
of interest charges go unpaid; the charges get added to the loan balance. As a result,
the loan balance increases over time, and this led a larger loan amount. The principal
balance of a loan increases when payments are postponed during periods of
deferment or forbearance and unpaid interest is capitalized. As a result, more
interest may accrue over the life of the loan, the monthly payment amount may be
higher, or more payments may be required.

According to USA office of the comptroller of the currency, the appropriateness of

interest capitalization for accounting purposes is based primarily upon the
creditworthiness of the borrower. Examining credit worthiness of the borrower
should answer questions like; was interest capitalization anticipated upon approval
of the initial loan based upon a planned temporary lack of borrower cash flow?, is
the loan well secured either by collateral in the form of liens on or pledges of real or
personal property, including securities, that have a realizable value sufficient to
discharge the debt (including capitalized and accrued interest) in full, or by the

1
guaranty of a financially responsible party?, is repayment of the loan, including
capitalized interest, based upon a reasonably ascertainable event in the future?, can
the borrower obtain funds from sources other than the existing creditor at similar
rates and terms?, and is there little or no doubt as to the ultimate collection of all
principal and interest? If the answers to the above questions are predominantly
affirmative, then interest capitalization may be acceptable.

DBE provides development finance to creditworthy borrowers and viable

investment projects based on the government priory area projects by mobilizing
local funds and other development loans provided by international organizations for
development purpose. Since from its establishment, non-performing loan increased
from year to year in terms of amount and in the numbers of projects. DBE
rehabilitate sick projects to minimize project failures and loan default risks/cost/
and to maximize loan recovery. According to the loan manual of the bank (2016)
when the positive cash flow of the project is considered to be minimal or
insignificant to settle interest arrears, the bank may apply appropriate project
rehabilitation mechanisms. Along with this the credit policy of the bank (2017)
permitted Interest capitalization as a relief measure for financed projects that face
temporary problems. As a result of restructuring interest through capitalization or
amortization measures, the debtor must return to the normal parameters of
repayment.

Theoretically there are so many reasons as to why loans fail to perform and forced
the lenders to follow relief measures in the time of difficulty. Some of these include
depressed economic conditions, high real interest rate, inflation, lenient terms of
credit, credit orientation, high credit growth and risk appetite, and poor monitoring.
Therefore making an assessment on the cause and effect on interest capitalization
and interest amortization is crucial to understand the gap and to take remedial
solution for the loan quality of the bank.

1.2. Statement of the Problem

Poor loan management will contribute to NPLs. It is critical issue for every bank to
manage bad loans. Many countries are suffering from Nonperforming Loans (NPLs)

2
in which banks are unable to get profit out of loans (Petersson and Wadman, 2004).If
the loan is well managed; it will increase the bank’s profitability and sustainability in
the future. The banks were forced to institute strategies to deal with problems when
financed projects faced difficulty in order to survive in the long run. Most of them
have established in-house divisions or departments to restructure the bad loans. A
restructured loan account is one where the lender, for economic or legal reasons
relating to the borrower’s financial difficulties, grants concessions to the borrower
that it would not have otherwise considered. Restructuring would normally involve
modification of terms of the advances/ securities including alteration of repayment
period/repayable amount/the amount of installments/rate of interest.
Restructuring of loans also occurs due to sanction of additional loan for meeting cost
overruns due to cost escalations, delayed implementation of projects, increased
scope of the project etc. According to the Romanian Association of Banks (2009),
through the process of loans restructuring banks assume a new risk, for which is
required a rigorous analysis of the past customer’s conduct and business, until the
moment it requires the loan to be restructured, the payment capacity features
(analysis of current contracts and cash flow), an economic and financial analysis and
an assessment of client ability to repay debts already accumulated.

DBE has introduced loan restructuring and rescheduling method to manage and
rehabilitate sick projects. Granting restructuring and rescheduling measures help to
pave the way for non-performing borrowers to exit their non-performing status or to
prevent performing borrowers from reaching a non-performing status. One of the
key objectives in a sustainable restructuring arrangement is to enable a borrower to
meet the original or amended terms of the loan over the remaining term, given the
borrower’s unique set of circumstances. Through interest capitalization and
amortization measures DBE has also attempted to give relief for financed project
when they face temporary problems. Between the periods 2011- 2020 a total of Birr
435,387,494 and Birr 917,352,764 interest amount capitalized for projects under
implementation and operational projects, respectively. In the same time periods Birr
944,420,723and Birr 4, 182,1798 interest amount also amortized for projects under
implementation and operational projects, respectively. Therefore, making an

3
assessment on the cause and effect of such interest capitalization and amortization
measure on DBE loan portfolio quality is vital to take remedial solution that help to
minimize the consequent credit risks.

1.3. Research Questions

Taking under consideration the purpose of the study, this research attempted to
answer the following questions:

1. What are the projects type and nature under interest capitalization and
amortization?
2. What are the major causes of interest capitalization and amortization under
project finance in DBE?
3. What are the effects of interest capitalization and amortization on the
performance of the projects?
1.4. Objectives of the Study

1.3.1. General Objective

The main objective of the study was to make an assessment on the cause and effects
of interest capitalization and interest amortization of DBE financed projects under
implantation and at operational stage.

1.3.2. Specific Objectives of the Study

The specific objectives of the study were;

 To examine projects type and nature under interest capitalization and

amortization
 To investigate major causes of interest capitalization and amortization under
project finance in DBE
 To identify the effect of interest capitalization and amortization on the
performance of the projects

1.5. Scope of the Study

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The study will be delimited on making an assessment on the cause and effect of
capitalizing and amortizing interest arrears in DBE. The study will only focus on
Projects financed at head office and District level in the time period between 2011-
2020.

1.6. Limitation of the Study

Methodologically this study considers only the perception of contact officer of the
project in which their interest capitalized and amortized. Others like team managers
and branch managers were not considered. The study also used only structured
questionnaire and secondary data, it did not consider interview which might give
detail information about the case.

1.7. Significance of the Study

This study will help DBE to identify the causes of interest capitalization and
amortization and its impact on bank’s loan performance. It also helps the bank to
take necessary corrective action to reduce credit risks related with interest
capitalization and amortization so as to enhance its operation effectively and
efficiently.

1.8. Organization of the Study

The organization of the study implies the flows of reports. Accordingly, this research
report has five chapters, references and appendix. The first chapter is introduction
that contains background of the study, statement of the problem, objective of the
study, significance of the study, scope and limitation of the study. The second
chapter consisted of literature review and some empirical review, etc. The third
chapter covered research methodology such as data sources and collection method
and analysis. The fourth chapter describes the result and discussion. The fifth
chapter focuses on conclusion and recommendation. The sixth chapter contains
reference and appendix.

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2. LITERATURE REVIEW
2.1. Loan Restructuring

When debtors are facing serious trouble in normal debt repayment, banks use
restructuring techniques like payment rescheduling, debt-equity swap and write-offs
to ease debtor’s debts and to help viable businesses to successfully survive recession
(Dedu, Lãzãrescu, & Niþescu, 2008). Loan restructuring can take two forms: soft
restructuring – that concerns only temporary postponements or small waivers
granted for credit facility (possibly a short period of grace for the payment of the
principal or extension of maturity, without modification of terms and conditions
initially agreed) and hard restructuring – addresses to debtor that are unable to
honour the debt service as it was originally approved, and requires a grace period

6
extended from the payment of the principal (usually at least one year), maturity
extension, partial or total transformation of a short term facility in a medium or long
term facility, complete re-evaluation of the credit relationship and repositioning of
the bank in relation to the debtor: cooperation position based on the determination
to pay of the debtor or the force position imposed by the debtor’s hostile attitude or
the lack of cooperation of it.

Problematic loans can be divided in two major categories: Viable credits that can be
recovered after the restructuring of terms and conditions, mostly of interest and
principal, while declaring insolvency remains last option; Non-viable credits that
cannot be reimbursed from cash flow generated in the normal course of the business
and the options of declaring the anticipated maturity and foreclosure are a priority.
In the second case, the speed of reaction of the banking institutions can be conclusive
and can mark the difference between the recovery of a bigger or of a smaller part of
the due debt.

2.1.1. Interest Capitalization/Amortization

Interest rate capitalization/amortization is one of debt restructuring technique

followed by lending institutions. Capitalized interest is interest that's added to a loan
balance. Instead of paying the interest as it comes due, the borrower let costs build
up. Because the interest charges go unpaid, the charges get added to the loan
balance. As a result, the loan balance increases over time, and the borrower end up
with a larger loan amount at graduation. As a result of capitalization, borrowers will
pay additional interest. This change happens in the form of higher monthly
payments or payments that last longer than they would have otherwise. In
accounting, capitalized interest is the total cost of interest for a project. Instead of
charging the interest costs annually, the interest costs are treated as part of a long-
term asset’s cost basis and depreciated over time. Unpaid interest is generally
capitalized following periods of deferment and/or forbearance, and following the
grace period on loan.

7
According to Financial Accounting Standard Board Interest capitalization is required
for those assets if its effect, compared with the effect of expensing interest, is
material. If the net effect is not material, interest capitalization is not required.
However, interest cannot be capitalized for inventories that are routinely
manufactured or otherwise produced in large quantities on a repetitive basis. To
qualify for interest capitalization, assets must require a period of time to get them
ready for their intended use. The interest cost eligible for capitalization shall be the
interest cost recognized on borrowings and other obligations. The amount
capitalized is to be an allocation of the interest cost incurred during the period
required to complete the asset. The interest rate for capitalization purposes is to be
based on the rates on the enterprise's outstanding borrowings (Financial Accounting
Standards Board, 2020).

According to International Accounting Standards (IAS 23R) interest rate

capitalization requires capitalization of borrowing costs associated with qualifying
assets (defined as those taking a substantial period of time to prepare for intended
use or sale). Qualifying assets can be inventories, plant and equipment, intangibles
and investment properties, unless the assets are accounted for at fair value (since
adding borrowing costs would cause carrying amounts to exceed fair value, which is
prohibited). Inventories that are routinely manufactured, or otherwise produced in
large quantities on a repetitive basis, are outside the scope of IAS 23R(Epstein &
Jermakowicz, 2008).Under GAAP interest capitalization is not used for inventory,
working capital expenses, or general maintenance and replacement of existing
machinery.

Amortization is the process of spreading a large payment out over a longer period of
time.  The classic example that most people are familiar with is a home mortgage. 
Very few people can afford to simply write a check that large, so amortizing the
payment on a fixed schedule over a period of years allows people to purchase a
home.  If the interest rate is fixed, then the payment will be the same each month for
the life of the loan, thus making it much easier to do some financial household
planning.  The percentage of each monthly payment that is the principal reduction

8
versus interest changes each month, however, with the percentage going to interest
decreasing steadily over time.

When a business makes a large capital investment (like buying an expensive piece of
equipment), they usually don't just write the entire purchase as a single enormous
expense for a given fiscal year.  Instead, they spread the accounting of the cost out
over a longer period of time.  They can do this because when they purchase the
equipment it doesn't automatically just remain a big liability.  Instead, they utilize
the asset to help them make money.  Ideally, the new asset will give the company the
ability to earn money that they wouldn't have been able to make without it.  Also,
the value of the equipment will lower over the years with use and wear.  So
capitalization allows a business to make a major asset purchase and still show a
profit at the same time as it puts the new asset to use.

Restructuring exercise refers to modification of principal terms and conditions of the

financing/loan, which may include change in the type or structure of the
financing/loan or other significant change to its terms. Restructuring exercise may
involve restructuring or conversion of the type or nature of the financing/loan such
as overdraft to term financing/loan or from revolving financing/loan into non-
revolving financing/loan. This exercise is to enable the customers to improve their
cash flow and overcome financial difficulties.

The key objective of loan restructuring measures is to pave the way for non-
performing borrowers to exit their non-performing status, or to prevent performing
borrowers from reaching a non-performing status. Forbearance measures should
always aim to return the exposure to a situation of sustainable repayment. When
looking at different forbearance solutions, it is useful to distinguish between short-
term and long-term measures implemented via forbearance. Most solutions will
involve a combination of different forbearance measures, potentially over a different
time horizon with a mix of short-term and long-term options.

9
2.1.2. Other Relief Measures

Borrower relief measures

Short-term, temporary Long-term, permanent

Conditional debt
Reduced payments forgiveness

Interest rate

Interest only reduction

Rescheduling
with NPV
Moratorium
reduction
Sale by owner
Reduced payments
Rescheduling/Extensio
Loan splitting
n of maturity dates

Capitalization of Note sale

Reduced payments
deferred debt
payments

Source: Adaptation from Handbook for MSME NPL Management and Workout.

10
A distinction can be made between short-term measures, aimed at providing
temporary relief to borrowers following a short-term disruption in income and cash
flows, and longer-term measures designed to reduce a borrower’s debt. Short-term
measures are appropriate to use when there is a reasonable expectation that the
borrower’s sustainable cash flow will be strong enough to allow the resumption of
its existing payment schedule at the end of the forbearance period. Notwithstanding,
the short-term measures in the figure above can be used in combination with longer
term solutions such as an extension of maturity, revision in terms, and additional
security. Specific short-term measures to consider include:

Reduced payments: the company’s cash flow is sufficient to service interest and
make partial principal repayments.
Interest only: the company’s cash flow can only service its interest payments, and no
principal repayments are made during a determined period of time.
Moratorium: an agreement allowing the borrower to temporarily suspend payments
of principal and/or interest for a clearly defined period, usually not to exceed 90
days. This technique is also often used in the beginning stages of a workout process
(especially with multi-bank borrowers) to allow the bank and other creditors time to
assess the viability of the business and develop a plan for moving forward. •
Rescheduling/extension of maturity - extension of the maturity of the loan (i.e., of
the last contractual loan instalment date) allows a reduction in instalment amounts
by spreading the repayments over a longer period.
Interest and repayment capitalization: adds deferred payments and/or deferred
interest to the outstanding principal balance for repayment under a sustainable
revised repayment program.
Longer-term/permanent options are designed to permanently reduce the borrower’s
debt. Most borrowers will require a combination of the options mentioned be-low to
ensure repayment. In all cases, the bank must be able to demonstrate (based on
reasonable documented financial information) that the borrower’s projected cash
flow will be sufficient to meet the restructured payment terms. Specific options to
consider include:

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Conditional debt forgiveness: involves the bank forfeiting the right to legally
recover part or the whole of the amount of an outstanding debt upon the borrower’s
performance of certain conditions. This measure may be used when the bank agrees
to a “reduced payment in full and final settlement”, where-by the bank agrees to
forgive all the remaining debt if the borrower repays the reduced amount of the
principal balance within an agreed timeframe. Banks should apply debt forgiveness
options carefully since the possibility of forgiveness can give rise to moral hazard;
weaken the payment discipline, and encourage “strategic defaults”. Therefore,
institutions should define specific forgiveness policies and procedures to ensure
strong controls are in place.
Interest rate reduction: involves the permanent (or temporary) reduction of the
interest rate (fixed or variable) to a rate that is more sustainable for the borrower.
This option could be considered when the evolution of interest rates has resulted in
the borrower receiving finance at an exorbitant cost, compared with prevailing
market conditions. However, banks should ensure that the lower interest rate is
sufficient to cover the relevant credit risk.
Rescheduled payments: the existing contractual payment schedule is adjusted to a
new sustainable re-payment program based on a realistic assessment of the
borrower’s cash flows, both current and forecast-ed. The rearranged payment
schedule usually leads to a reduction in debt in NPV terms. Rescheduled payments
are usually combined with an extension of maturity. In addition to normal
rescheduling, additional repayment options can include:
Partial repayment - a payment is made against the credit facility (e.g., from a sale of
assets) that is lower than the outstanding balance. This option is used to
substantially reduce the exposure at risk and to enable a sustainable repayment
program for the remaining outstanding amount. This option is generally preferable,
from the creditor’s stand-point, to the balloon, bullet, or step-up options described
below.
Balloon or bullet payments – are used in the case of more marginal borrowers
whose sustain-able cash flow is insufficient to fully repay the loan within the
rescheduled tenor. A balloon payment is a final instalment substantially larger than
the regularly scheduled instalments. As a rule, it should not exceed 30 percent of the

12
original principal amount of the loan. Bullet loans carry no regular instalment
payments. They are payable in full at the maturity date and frequently contain
provisions allowing the capitalization of interest (payment in kind interest)
throughout the life of the loan.
Step-up payments – should be used when the bank can ensure and demonstrate that
there is a good reason to expect that the borrower’s future cash flow will be
sufficient to meet increases (step-up) in payments.
Sale by owner/assisted sale: this option is used when the borrower agrees to
voluntarily dispose of the secured assets to partially or fully repay the debt. It is
usually combined with the partial repayment option or conditional debt forgiveness.
The borrower must be monitored closely to ensure that the sale is conducted in a
timely manner and the agreement should contain a covenant allowing the owner to
con-duct the sale if the borrower fails to do so within the specified timeframe.
Loan splitting: is used to address collateral and cash flow shortfalls. In this option,
the debt is split into two parts: (i) the portion representing the amount that can be
repaid from sustainable cash flow is repaid in equal instalments of principal and
interest (with a maturity not to exceed 5 years); and (ii) the remaining portion
represents “excess debt” (which can be subordinated). This portion may be further
split into several parts/tranches (which may be non-interest bearing or payment in
kind notes) and is frequently used in combination with payments from the sale of
specific assets or bullet payments at maturity.
Note sale: individual note sales are most commonly used when a new investor
wishes to restructure a company’s overall debt burden on commercially acceptable
market terms. This option is usually combined with conditional debt forgiveness and
requires that the purchase price be equal to or greater than the current NPV of the
restructured loan.

Additional measures are not considered to be viable stand-alone

restructuring/forbearance options as they do not result in an immediate reduction in
the loan. However, when combined with one or more of the previously identified
options, they can provide incentives for repayment or strengthen the bank’s overall
position.

13
Debt-to-asset swap: converts the loan, or a portion of the loan, into “other assets
owned” where the ultimate collection of the original loan requires the sale of the
asset. This technique is generally used in con-junction with conditional debt
forgiveness or partial loan repayment and maturity extension options. The
management and sale of real estate properties also requires specialized expertise to
ensure that the bank maximizes its returns from these assets.

Debt-to-equity swap: converts the loan, or a portion of the loan, into an equity
investment. Generally it is used to strengthen the capital structure of large highly
indebted corporate borrowers. Like the debt-to-asset swap above, this option may
also require the bank to allocate additional resources for managing the new
investment.

Debt consolidation: combines multiple exposures into a single loan or a limited

number of loans (more common for retail exposure). This solution should be
combined with other measures addressing existing arrears. This option is
particularly beneficial in situations where combining collateral and secured cash
flows provides greater overall security coverage for the entire debt than
individually.

Other alterations of contract/covenants: when entering a restructuring agreement, it

is generally necessary to revise or modify existing contracts/covenants to meet the
borrower’s current financial circumstances. Examples might include revising ratios,
such as minimum working capital, or providing additional time for a borrower to
sell excess assets.

Additional security: additional liens on unencumbered assets (e.g., pledge on a cash

deposit, assignment of receivables, or a new/additional mortgage on immoveable
property) are generally obtained as additional security from a borrower to
compensate for the higher risk exposure or cure existing defaults in loan-to-value
ratio covenants.

2.2. Factors that affect Loan repayment of Financed Projects

14
A number of factors may have an impact on the cash flow of the project, and project
financings are subject to a wider range of risks than other financing models (Fight,
2006). Possible risks that may evolve into project problems and eventual financial
distress, include project risks at start-up, credit risks, financial risks (also known as
macroeconomic risks), market risks, operational risks, and political risks (Hoffman,
2008). The potential of start-up risks occurring may prevent the project from
becoming operational, i.e. unable to generate sufficient cash flow. The typical project
risks at start-up include cost overruns, completion delays, technical problems, and
project inefficiencies (Hoffman, 2008).In the case of project financings the viability of
a project depends not only on the financial status of the project company/borrower,
but also other participants such as suppliers (Fight, 2006) and buyers of the project’s
produce (Hilmarsson, 2010). Therefore, the inability by a project company to sell its
produce as a result of credit issues on the part of off-takers could result in the project
encountering financial distress (Sorge, 2004).

Financial risks (macroeconomic risks) may occur outside of the project and the
sponsor’s control which could have a negative impact on the cash flow of the project
(Fight, 2006), resulting in financial distress. In the case of currency risk, when there
are differences in the revenue currency, on the one hand, and the debt and expenses
currency, on the other hand, and when fund transfers are cross-border (Hoffman,
2008) the project could encounter financial distress if:(i) a change in the exchange
rate between the currencies result in a liquidity shortfall (foreign exchange risk); (ii)
the one currency cannot be converted into foreign exchange due to the unavailability
of the foreign exchange (non-convertibility of currency risk); and (iii) currency
cannot be transferred out of the country due to exchange control issues (currency
transfer risk). In the case of interest rate risks materializing, a rise in interest rate
could negatively impact the project’s ability to service the debt (Finnerty, 2007). As
mentioned above, in the case of the Euro Disneyland Project the onset of a severe
recession in Europe resulted in an unexpected rise in interest rates and project input
costs. The significant adverse impact on the cash flow of the project resulting from
this caused the project to encounter financial distress (Finnerty, 2007).The
materialization of political risk may result in financial distress for a project, e.g.

15
should a relevant government withdraw its approval for the project (Fight, 2006).
Political risk is catastrophic by nature, potentially imposing significant losses
(Galvao, 2001). A case in point is the USD 28 billion Dabhol Power project in India
(Hoffman, 2008). Following a political change in the area where the project was
located soon after completion of the financing, the government withdrew its support
for the project. This led to the abandonment of the project resulting in significant
losses to the project sponsors, including the (now defunct) Enron Corporation and
General Electric Capital

3. METHODOLOGY

3.1. Research Design

To achieve the objective of the study, the researchers used descriptive research
design to identify the major causes and effects of interest capitalization and
amortization in Development Bank of Ethiopia. The research strategies employed in

16
this study were both quantitative and qualitative (mixed methods) approach. The
quantitative aspect of study helps to seek information that can be generalized about
the association between Macroeconomic factor, bank specific factors and borrower
specific factors with interest capitalization and amortization in DBE. On the other
hand, the purpose of the qualitative strategy is to search for data that can
supplement the gap that can’t not captured by the quantitative survey and to obtain
deeper understanding of the macroeconomic factor, borrower and bank specific
factors that causes the occurrence of capitalizing and amortizing interest in DBE.

3.2. Instruments of Data Collection

In the study both primary and secondary data were collected. The data for the study
was collected only from projects that are under the categories of interest
capitalization and amortization in the time period from 2011 - 2020. In order to
collect primary data, the researchers used structured questionnaire. Questionnaires
were dispatched to the credit staffs both at head office and district to identify the
major causes of interest capitalization and amortization through the Google form
platform. As far as the secondary data is concerned, DBE loan position and
repayment history of projects and the annual reports of the bank, manuals, directives
and procedures were be used.

3.3. Population and Sample Selection

The participants (subjects) of the study were all DBE financed projects under interest
capitalization and amortization in the time period 2011- 2020 at head office and

17
 district. Project under implementation and at operational stage in the time frame of the study were included. All projects (both at
head office and district) in which their interest capitalized and/or amortized between 2011- 2020 were taken as a sample for the
study. The number of sample projects for the study in each working units indicated as follow:

Table 3-1: Sample projects for the study in each working units

Sr.No Working Units Under gone interest Under gone Interest amortization Remark
capitalization

Under Operational Under Operational

Implementation Implementation
1 Adama District 8 8 - - 1 project capitalized twice

2 Addis Ababa 7 7 - -
District

3 Bahir Dar District 1

4 CRMD I 2
1 project interest capitalized both at
5 implementation and operation
CRMD II 3 3 - 1
2 project interest capitalized twice both
at implementation and operation

6 CRMD III 4 - - -
2 projects capitalized twice both at
7 CRMD IV 3 3 1

18
 implementation and operation

1 project interest amortized four times

2 projects interest capitalized and
8 amortized at operational
Dessie District 2 2 1 2
1 project interest capitalized and
amortized at implementation

9 Gambella District 12 5 - -

10 Gonder District - 48 - -

11 Hawasa District 10 - 3 2

12 Jimma District - - - 2

13 Mekele District 2 2 - -

14 Nekemte District 5 4 1 2 1 project interest amortized both at

implementation and operational stage

15 WolayitaSodo 2 2 - -

16 PRLRD I 5 5 - -

17 PRLRD II 2 - - -

19
3.4. Method of Data Analysis

In this study descriptive analysis utilized based on a panel data from 2011-2020 to
examine the cause and effect of interest capitalization and amortization in DBE. The
data collected from different sources were coded, checked and entered to simple
excel program to make the data ready for analysis. For descriptive analysis; table
and percentage were used to analyze the data.

20
4. DATA ANALYSIS AND DISCUSSION

Under this section, data collected from the respondents through questionnaire and
the secondary data obtained from different working units analysed using deceptive
statistics.

4.1. Interest Capitalization and Amortization Trends in DBE

Between the periods 2014- 2020 a total of Birr 569,248,927.72 and Birr 962,882,606.14
interest amount were capitalized for projects under implementation and operational
projects, respectively. In the same time periods, Birr 935,672,888.57 and Birr
37,006,865.548 interest amount also were amortized for projects under
implementation and operational projects, respectively. The following figure depicts
trends of amount of interest capitalized and the total loan amount of the project
under interest capitalization.

Figure 4-1: Amount of interest capitalized and total amount of loan under interest
capitalization in DBE

Based on the above figure results, during the 2014 fiscal year, amount of interest
capitalized was Birr 47,846,206. In the fiscal year of 2015, it declined to Birr
2,046,091.02. During 2017 fiscal year, the amount of the amount of interest

21
capitalized began to rise to Birr 171,520,178.99. Again during 2018 fiscal year,
amount of interest capitalized increased to Birr 610,960,940.66. But in 2019, it
declined to Birr 327,173,012.48. In 2020 fiscal year, it began to increase to Birr
372,585,104.75. In general, the above figure shows that as the amount of loan rises
the amount of interest capitalized also increases from time to time, except 2019.

Figure 4-2: Amount of interest capitalized under implementation stage and

operational stage

The figure 4-2 depicts that the amount of interest capitalized at operational stage is
much higher than amount of interest capitalized at implementation stage, except in
2014. The trend also shows that in DBE number of projects in which their interest
capitalized is also higher at operational stage (seen figure 4-3) compare to project at
implementation stage.

Figure 4-3 Number of project under interest capitalization (2014-2020)

22
Based on the above figure results, during 2014 fiscal year, the number projects under
interest capitalization at under implementation and operational stages were very
few and only one project under implementation stage was under interest
capitalization. However, the number of projects under interest capitalization started
increasing during 2017 fiscal year and 8 projects under implementation and 9
operational projects became under interest capitalization.

During 2019 fiscal year, 43 operational projects and 20 under implementation

projects became under interest capitalization which was the highest number of
projects under interest capitalization. However, it started declining in 2020 which is
better if it continues declining in future.

4.1.1. Interest Capitalization among Working Units

Data were collected from head office and districts to examine the existing status of
capitalized interest across each credit working units of DBE. According to the data
(see table 4-1) among the working units large number of projects (48 projects)
interest capitalized was from Gondar District followed by Gambella, Adama and
Addis Ababa Districts, 17 project, 16 projects and 14 projects, respectively. However,
of the total loan amount of projects under interest capitalization the highest ratio of
capitalized interest recorded on Wolayita Sodo Distict (19.6%), Dessie District

23
(18.3%), and PRLRD I (17.5%) and Hawasa District (16.6%). But among the total
amount of interest capitalized in DBE CRMD IV and CRMD II took the highest ratio
(35.2% and 32.3%, respectively). This indicates that this two working units alone
took majority amount of interest capitalized in DBE (67.5%)

Table 4-2: Interest capitalization across DBE working units

Loan Amount Amount of
S/N Name of Project Interest Capitalized Ratio of
Districts/Working Number A Capitalization interest capitalized
unit ratio (B/A) interest from
B the total
capitalized
interest of DBE

1 Addis Ababa 14 303,902,270.21 32,659,025.68 10.7% 2.1%

2 Adama 16 319,586,427.12 47,425,266.96 14.8% 3.1%

3 Bahir Dar 1 24,355,725.32 2,596,788.52 10.7% 0.2%

4 CRMD I 2 199,333,651.00 12,461,920.08 6.3% 0.8%

5 CRMD II 9 4,628,286,389.80 495,416,952.27 10.7% 32.3%

6 CRMD III 4 514,411,316.62 40,222,256.52 7.8% 2.6%

7 CRMD IV 8 5,008,574,680.74 538,547,326.50 10.8% 35.2%

8 Dessie 4 71,289,664.08 13,069,264.12 18.3% 0.9%

9 Gambella 17 295,468,087.30 42,418,598.76 14.4% 2.8%

10 Gonder 48 445,871,284.26 52,661,023.30 11.8% 3.4%

11 Hawassa 11 203,508,545.90 33,784,263.69 16.6% 2.2%

12 Mekele 5 95,862,395.45 12,422,293.43 13.0% 0.8%

13 Nekemte 10 149,810,525.38 21,266,903.88 14.2% 1.4%

14 PRLR I 10 1,006,120,026.88 175,641,662.80 17.5% 11.5%

15 Wolayta Sodo 4 58,926,927.46 11,537,987.35 19.6% 0.8%

Total 163 13,325,307,917.52 1,532,131,533.86 11.5%  

24
4.1.2. Interest Amortization

Interest amortization is among the relief measures in the time of difficulty or when
the borrower financially incapable of meeting its financial obligations. Between the
time periods of 2013- 2020 a total amount birr 972,679,754.118 interest amortized in
DBE. The overall trend of interest amortization in DBE indicates that, of the total
amount of project loan under interest amortization (1,953,485,771.49 birr), 49.8% of
interest amortized, which almost half of the total loan amount. When uncollected
interest increases it will hurt the financial performance of the bank. Banks mainly
make money from the interest they charge on loans, and when they are unable to
collect the owed interest payments, it means that they will have less money available
to create new loans and pay operating costs. Holding a high amount of amortized
interest relative to the total assets of a bank poses a huge risk to the bank. When the
percentage of amortized interest rises, the bank may face liquidity problem .

Table 4-3: Interest amortization trend in DBE

Amount of
Numbe  Ratio of amortized
project Loan Amount of Interest
Year r of interest in line with
under interest Amortized
Projects amount of loan
amortization
2013 1 8,732,386.02 1,148,414.84 13.2%
2015 1 9,318,506.10 2,207,010.33 23.7%
2016 4 194,268,094.85 25,850,382.68 13.3%
2017 3 1,708,543,573.52 936,780,341.03 54.8%
2018 - - - -
2019 2 31,758,238.01 6,667,038.23 21.0%
2020 1 864,972.99 26,567.01 3.1%
sum 12 1,953,485,771.49 972,679,754.12 49.8%

4.1.3. Interest Amortization across Working Units

As table 4-3 indicates among working units’ relatively large number of projects (5)
interest amortized in Hawasa District followed by Nekemte District (3). However in
terms of amount of interest amortized CRMD IV took the leading. In this working
unit for one project alone 55.2 %( 934,270,305 birr) interest amortized of the total loan
amount of the project. This shows that the existence of large amount of uncollected

25
interest in this working unit which will affect the loan status of the project and also
lead credit burden.

26
Table 4-4: Interest Amortization across working units

S/N Districts Name Project Loan Amount Amount of Ratio of

Number A Interest amortized
Amortization interest
B B/A

1 CRMD II 1 183,049,429.24 24,447,799.11 13.4%

2 CRMD IV 1 1,691,810,000.00 934,270,305.00 55.2%

Hawasa
3 District* 5 21,402,144.70 3,636,160.91 17.0%

4 Jimma 2 31,758,238.01 6,667,038.23 21.0%

Nekemte
5 District 3 25,465,959.54 3,658,450.87 14.4%
*Hawasa District Made amortization for one project twice

The following table shows that among the total number of project under interest
capitalization and amortization large number of projects interest capitalized at
operational and implementation stage, 54 and 52 projects respectively. Significant
number of projects (19) interest capitalized twice at operational stage.

Table 4-5: Number of project under interest amortization and capitalization and
number of actions

S/N Action Number of Projects

1 Capitalized twice at operational stage 19
2 Capitalized twice at implementation stage 6
3 Capitalized at implementation and operational stage 3
4 Capitalized at implementation stage 51
5 Capitalized at operational stage 54
6 Capitalized and Amortized 2
7 Amortized Once 8
8 Amortized Twice 1
  Total 144

4.1.4. Interest Amortization and capitalization across Economic Sectors

As figure 4-4 depicts that among the total number of projects in which their interest
amortized and capitalized the largest proportion (59%) is occupied by agricultural

27
sector and followed by manufacturing sector, which is 26%. This data indicates that
financing agricultural sector is the most risky area, since the presence of large
amount of capitalized and amortized interest show projects failure to fulfil their
commitment.
Figure 4-4: Interest capitalization and amortization across economic sectors

4.1.5. Loan status/classification of the project at the time of Interest

capitalization and Amortization

Among the total number of project reviewed in this study 33% of the projects at
doubtful, 23% at substandard, 21% of projects at pass, 12% of the projects at special
mention and 11% at loss status their interest capitalized and or amortized. Making
interest capitalization for projects which are under loss, doubtful and substandard
status will affect the loan recovery of the project. The credit policy of DBE also
underline on making interest capitalization for projects that face temporary financial
problem, instead of making interest amortization for projects under loss, doubtful
and substandard status.

Figure 4-5: Loan status of the project at the time of interest capitalization and
amortization

28
4.2. Descriptive Statistics on the Cause and Effect of Interest
Capitalization and Amortization

Based on the follow up reports the respondents have already conducted at their
working units, they were asked the possible causes of interest amortization and
capitalization in DBE. Consequently, the causes were categorized as cost related,
revenue related and other factors and they have been discussed as follows;

4.2.1. Cost Related Factors

Under cost related factors issues such as unit costs, level of the provisions, financial
losses (generated mainly by foreign exchange losses), short term debt and
fluctuation of personnel were addressed. Accordingly, the results of each cost related
factors have been shown on the figure below;

Figure 4-6: Cost related causes for interest capitalization and amortization in DBE

29
As can be seen from the above figure, of the cost related factors depicted, the
perception of the respondents on unit costs was the highest result (46.2%).  This
implies that the respondents are highly agreed on that among the cost related
factors, unit costs are the major factor for the interest capitalization and amortization
in DBE. Besides, based on the response of the respondents, fluctuation of personnel
(24.8%) and financial losses (generated mainly by foreign exchange losses) (17.9%)
were the second and third main causes of interest capitalization and amortization of
cost related factors next to unit costs. On the other hand, levels of provisions (4.3%)
and short term debt (6.8%) have lower impact on interest capitalization and
amortization.

4.2.2. Revenue Related Factors

The second factors the respondents were asked as possible causes of interest
capitalization and amortization in DBE were revenue related factors. Under revenue
related factors parameters such as loss of market share problem, decline income
from sales, current liquidity ratio problem and cash flow level decline were
employed. Consequently, based on the response of the respondents, the results of
each parameter have been show on the following figure.

30
Figure 4-7: Revenue related causes for interest capitalization and amortization in
DBE

Based on the result of the above figure, decline income from sales (41.1%) was the
major cause of interest capitalization and amortization in DBE from revenue related
factors.  The second main cause of interest capitalization and amortization among
revenue related factors was loss of market share problem (23.4%). This issue was
also supported by the open ended question related to the possible cause of interest
capitalization and amortization in DBE. As a result, of the issue raised by the
respondent during open ended question on the possible cause of interest
capitalization and amortization in DBE, about 5.8% was market problem. On the
contrary, current liquidity ratio problem (19.4%) and cash flow level decline (16.1%)
were relatively the lower possible cause of interest capitalization and amortization
from revenue related factors.

4.2.3. Other Factors

For the question raised for the respondents on the possible cause of interest
capitalization and amortization, other factors such as political instability, project
implementation delay, natural catastrophes, temporary management problem, raw
material and other supplies shortage in the market, and design change were

31
addressed. Consequently, the results of these parameters have been revealed on the
below figure;

Figure 4-8: Other factors that causes for interest capitalization and amortization in
DBE

The result of the above figure indicated that political instability (27.2%) was the
major cause of interest capitalization and amortization in DBE. This case was also
supported by the issue raised on the open ended question related to the possible
cause of interest capitalization and amortization in DBE, which political instability
took large share (20%) almost similar with the result stated above (27.2%). This
implies that political instability in the country took major share for interest
capitalization and amortization in DBE. Next to political instability, project
implementation delay (25.4%) took large share in possible cause of interest
capitalization and amortization in DBE. Besides, project implementation delay also
rose as main cause of interest capitalization and amortization during the open ended
question which was 13.5%.  The result of other factors such as natural catastrophes,
temporary management problem, raw material and other supplies shortage in the
market, and design change were 16.0%, 12.4%, 11.2% and 7.7% respectively. This
elucidates their share for interest capitalization in DBE were not such much
significant and crucial.

32
4.3. Issues Raised on Open Ended Questions Related to the Possible
Cause of Interest Capitalization and Amortization

Besides closed-ended questions, the study team has raised the possible causes of
interest capitalization and amortization on open ended questions for the
respondents. As a result, the following issues were raised and they are ranked
according to their major share starting from political instability to design change.

Table 4-6: Respondents’ idea on the possible causes of interest capitalization and amortization

Causes to undertake interest Number of projectsPercentage Under

restructuring under the problem implementation

Political instability and security 31 20.0% 4

problem

Harsh weather condition, heavy 22 14.2%

rainfall and windstorm

Project implementation delay 21 13.5% 17

Pests and insects 19 12.3% 1

Electric power shortage and 10 6.5% 2

interruption

Shortage of raw material and raw 10 6.5% 2

material price escalation

Market problem 9 5.8%

Failure to include the all 5 3.2% 4

necessary investment items at
project appraisal and
disbursements

Foreign currency problem 5 3.2% 1

Cost overrun on different 4 2.6% 2

33
investment items 

Lack of accessories for machines, 4 2.6%

high maintenance and repair cost

To reduce NPL ratio 4 2.6% 2

Covid-19 pandemic 3 1.9% 1

Shortage of working capital 3 1.9%

The promoter changed approved 2 1.3%

commodity

Prolonged time taken for custom 1 0.6%

clearance and logistics service

Devaluation of birr 15% of every 1 0.6%

one dollar

Design change 1 0.6%

As can be observed from the above table, of the issues raised on the possible causes
of interest capitalization and amortization in DBE, political instability and security
problem took the major share which was 20%. This implies that most of interest
restructuring was undertaken by the bank due to political instability and security
problem. The second main possible cause of interest capitalization and amortization
was harsh weather condition, heavy rainfall and windstorm (14.2%). In addition,
project implementation delay (13.5%), and pests and insects (12.3%) were also raised
as main possible cause of interest capitalization and amortization next to the political
instability, and harsh weather condition. Accordingly, on 17 projects under
implementation, interest capitalization and amortization was done by the Bank.

Furthermore, issues such as electric power shortage and interruption (6.5%),

shortage of raw material and raw material price escalation (6.5%), and market
problem (5.8%), failure to include the all necessary investment items at project
appraisal and disbursements (3.2%), foreign currency problem (3.2%),  cost overrun
on different investment items (2.6%), lack of accessories for machines, high

34
maintenance and repair cost (2.6%), to reduce NPL ratio (2.6%), covid-19 pandemic
(1.9%), shortage of working capital (1.9%), and the promoter changed approved
commodity (1.3%) were also relatively raised as possible cause of interest
capitalization and amortization in DBE.

On the contrary, of the issues raised as possible cause of interest capitalization and
amortization, issues such as prolonged time taken for custom clearance and logistics
service (0.6%), devaluation of birr 15% of every one dollar (0.6%), and design change
(0.6%) took insignificant share.

4.4. Adherence to the General Principles of Restructuring

The principal criterion the banks consider while deciding on the choice of course of
action in interest restructuring is that of maximising returns in assets employed,
given existing risk factors and the time needed to recover funds. The logic
underlying this criterion is obvious, yet its practical application is very difficult and
requires detailed study of the bank's financial and asset position, as well as of the
current situation of the project, origins of the crisis and possibilities of combating it.
Contact officer of the projects in which their interest amortized and or capitalized
were asked whether the interest restructuring was made based on the general
principle of interest restructuring (interest amortization and capitalization). Among
the respondents 60.0% agreed on the existence of looking the future viability of the
project not only resolving its financial aspects while making interest restructuring in
the form capitalization and amortization. But the remaining 40% of the respondents
didn’t agree on the practice. Using the most accurate information about the project
and the borrower has agreed on all the terms and conditions of restructuring is very
important in the time of interest capitalization and amortization. However, only
47.5% of the respondents agreed on its practice in DEB. Among the respondents
63.8% of them agree that the interest restructuring was not made merely to conceal
inefficient loans gathered in portfolios. The data on table 4-6 also indicates that
81.3% of the respondents agreed on changing the credit terms and conditions has
taken into consideration rather to be covered with collateral while making interest
capitalization and amortization.

35
 Table 4-7: Respondents Degree of agreement on adherence to the general principle of
restructuring in the time of interest capitalization and amortization

Adherence to the general principles

Strongly strongly Agree + S.
restructuring (Interest capitalization Disagree Neutral Agree
Disagree Agree Agree
and/or amortization) process

Proving future viability of the project not

3.8% 17.5% 12.5% 47.5% 18.8% 60.0%
only resolving its financial aspects

Using the most accurate information

about the project, and the borrower has
8.8% 12.5% 11.3% 36.3% 31.3% 47.5%
agreed on all the terms and conditions of
restructuring.

The restructuring was not made merely

to conceal inefficient loans gathered in 7.5% 18.8% 27.5% 36.3% 10.0% 63.8%
portfolios

The bank has closely supervised the

process of restructuring and coordinating 5.0% 7.5% 17.5% 46.3% 23.8% 63.8%
all borrowers’ actions

The decisions of restructuring was taken

only on the basis of well checked
10.0% 18.8% 50.0% 12.5% 8.8% 62.5%
information and certified by an
external /internal auditor.

Changing the credit terms and conditions

has taken into consideration rather to be 8.8% 6.3% 32.5% 48.8% 3.8% 81.3%
covered with collateral

4.5. Effect of Interest Capitalization and Amortization

Interest capitalization may have different effects on the projects. Accordingly, the
respondents were asked the effects of interest capitalization and amortization on the
projects.  As a result, the respondents raised different issues regarding the effects of
interest capitalization on the projects.  These issues are summarized and depicted on
the following figure below;

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Figure 4-9: Respondents’ idea on the effect of interest capitalization and amortization

The result of the above figure revealed that the major effect of interest capitalization
and amortization is to help the project to get financial relief and sustained its
business operation (52.4%). This implies that majority of the respondents agreed that
interest capitalization and amortization is important to help the project to get
financial relief and sustained its business operation.  

Of the other issue raised on the effect of interest capitalization and amortization, the
second major idea raised was that interest capitalization and amortization increase
debt burden on the borrowers (16.7%). On the contrary, of the issues raised by the
respondents, about 13.1% revealed that interest capitalization has no observable
effect on the project.

Furthermore, even if they do not take major shares, some issues have been raised as
the effect of interest capitalization and amortization by the respondents. These are:
Loan status of the project improved (7.1%), the collateral coverage and equity
contribution decline (3.6%), project implementation finalized (3.6%), it encourage
wilful defaulters (2.4), improve loan status of the project (1.2%).  

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4.6. What if Interest Capitalization and Amortization was not made?

For the question raised for the respondents what would happen to the projects if
interest restructurings were not made, some issues were raised as shown the below
figure;

Figure 4-10: Respondents idea on the final consequence of limiting interest

capitalization and amortization

Based on the result of the above figure, of the issues raised on what would happen
on the projects if interest capitalization and amortization were made, loan default
and the project unable to operate (48.7%) took the major share. This implies that the
respondents strongly agreed on that interest capitalization and amortization is
important for the projects in problem.  Besides, of the issues raised by the
respondents on what would happen on the project if interest restructuring was not
made, foreclosure (22.4%) would happen which was not good for the project.

Even though they do not take large shares, the following issues were raised by the
respondents on the projects if interest restructuring was not made;

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  The status of the project would remain in NPL (11.8%)
 Financial stress would happen (7.9%)
 The project would fail to start operation (6.6%)
 Nothing has changed; the project has still non-performing (2.6%).

In general, based on the above result we can conclude that interest capitalization and
amortization has importance for the project in problem if properly managed.

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5. CONCLUSION AND RECOMMENDATION

5.1. Conclusion

Effective credit management help banks not only support the viability and
profitability of their own business but also contribute to systemic stability and to an
efficient allocation of capital in the economy. This study was aimed to assess the
cause and effect of interest capitalization and amortization for projects at operational
stage and implementation stage. Between the time periods 2014- 2020 a total amount
of birr 1,532,131,533.86 and 972,679,754.118 interest capitalized and amortized,
respectively. The trend of DBE interest capitalization and amortization indicates
that, it is rising year to year. Amount of interest capitalization is high at operational
stage of the project while amount interest amortization is high at implementation
stage of the project. The finding of the study also indicates that the largest portion of
capitalized interest in DBE is more dominated by CRMD IV and II, which alone
encompass 67.5% of the total interest capitalized in DBE. The same working unit
(CRMD IV) alone also took 55.2% of the total interest amortized in DBE. This tell us
the existence of troubled project in those working units which need special attention,
since it has final impact of the financial performance and loan status of the bank.

The finding of the study also showed that among the total number of project in
which their interest amortized and capitalized the largest proportion (59%) is
occupied by agricultural sector and followed by manufacturing sector, which is 26%.
The data also indicates that 33% of the projects interest capitalized and amortized at
doubtful, 23% at substandard, 21% of project at pass, 12% of the project at special
mention and 11% at loss status.

Data were collected from the contact officer of the projects in which their interest
capitalized and amortized through structured questionnaire. According to the data
obtained from the respondents among cost related factors unit costs (46.2%) was the
major factor for the interest capitalization and amortization in DBE followed by

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fluctuation of personnel (17.9%); whereas among revenue related factors for interest
capitalization and amortization in DBE decline income from sales was the major cause
(41.1%) followed by loss of market share problem (23.4%). Along with these other
factors political instability (27.2%), project implementation delay (25.4%), natural
catastrophes (16.0%), temporary management problem (12.4%), raw material and
other supplies shortage in the market (11.2%), and design change (7.7%) also led for
interest capitalization and amortization in DBE.

Among the issues indicated by the respondents on the open ended question for the
cause of interest amortization and capitalization political instability and security
problem, harsh weather condition, heavy rainfall and windstorm, project
implementation delay and pests and insects were the major one. Causes like electric
power shortage and interruption, shortage of raw material and raw material price
escalation and market problem, failure to include the all necessary investment items
at project appraisal and disbursements, foreign currency problem, cost overrun on
different investment items, lack of accessories for machines, high maintenance and
repair cost were also relatively raised as possible cause of interest capitalization and
amortization in DBE.

Finding of the study also indicates that making interest amortization and
capitalization has both positive side and negative side effect. Among the positive
side helping the project to get financial relief and sustained its business operation,
project implementation finalized and improving loan status of the project were
mentioned. Whereas the negative side effect mentioned by the respondents were
increase debt burden on the borrowers, the collateral coverage and equity
contribution decline and encourage wilful defaulters.

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5.2. Recommendation

Based on the findings of the study, the study team has drawn the following
recommendations;

 Interest restructuring request of the client should be accepted if credit processing

unit and the bank management ensure that the project cash flow is well
previously and problem faced the project is temporary.
 The bank should only consider interest restructuring (interest capitalization and
amortization) for clients who have good repayment history.
 Interest restructuring of the bank should only consider for projects in which their
loan status/ classification is either pass or special mention, since making the
interest restructuring for projects under substandard, doubtful and loss status
might affect the loan recovery of the bank.
 The credit processing unit should work to shorten project implementation so as
to enable the project to generate income within the intended time.
 The interest capitalization should consider debt equity ratio and should ensure
the capitalized interest is covered with adequate collateral
 To minimize interest arrears restructuring in the long run (either in capitalization
form or amortization from) the bank should make adequate feasibility study to
ensure the project is profitable and has adequate market access.
 Bank Restructuring should not be done in order to conceal inefficient loans
gathered in portfolios.
 The bank should generally avoid offering interest capitalization and amortization
more than once and the interest capitalization should only be applied to arrears
that do not exceed a predefined size relative to the overall principal.

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6. REFERENCES

Dedu, V., Lãzãrescu, S. A., & Niþescu, D. C. (2008). Banking Restructuring

Techniques in the Economical Crisis Context. Theoretical and Applied Economics ,
27-32.

Epstein, B. J., & Jermakowicz, E. (2008, May 1). Retrieved from

https://www.journalofaccountancy.com/issues/2008/may/interestcapitalizationon
esmallsteptowardconvergence.html

Financial Accounting Standards Board. (2020, August 04). Summary of Statement

No. 34 . Retrieved from Capitalization of Interest Cost (Issued 10/79):
https://www.fasb.org/summary/stsum34.shtml#

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7. Appendix

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