Introduction to Corporate Finance

PArT 3: CAPITAL BUDGETING

Ignoring Financing Costs

Much of this chapter focuses on which cash flows to include in calculating a project’s NPV. We should

also mention an important category of cash flows which should be excluded – financing cash flows.

When calculating a project’s NPV, analysts should ignore the costs of raising the money to finance

the project, whether those costs are in the form of interest expense from debt financing or dividend

payments to equity investors. It may seem counterintuitive to exclude costs such as interest expense

from an investment’s cash-flow calculations, but it is necessary to do so because these are accounted

for in the process of discounting future cash flows. When analysts discount a project’s cash flows, the

chosen discount rate takes into account the opportunity that investors have to invest in other companies

or projects. Therefore, if an analyst deducted cash outflows to investors, such as interest and dividend

payments, the analyst would, in effect, double-count the financing costs of the investment.

If we finance an investment

project with debt, how should

we handle interest expenses in

the NPV calculation?

thinking cap
question

1 For simplicity, we assume that there is no depreciation expense associated with this investment.

example

One of the company’s financial analysts calculates

that the project will generate $70,000 each year in

after-tax cash, but this calculation includes both the

investment’s operating cash flows and its financing

cash flows – interest expense – as shown below:

Sales $ 440,000

Operating expenses –300,000

Interest expense – 40,000

Pre-tax cash flow $ 100,000

Taxes (30%) – 30,000

After-tax cash flow $ 70,000

Now let’s see whether the company would

accept or reject this project, based on these cash

flow numbers. If the project costs $1 million up-front

and generates cash inflows of $70,000 per year (in

perpetuity), its NPV is negative:

$1,000,000

$70,000

0.098

NPV=− +=−$285, 714

Is rejecting this investment the right decision?

One way to answer this question is to ask whether

shareholders and bondholders are satisfied

with the payments they receive as a result of

the investment. Each year bondholders receive

$40,000, which represents an 8% return on their

investment ($40,000 ÷ $500,000). In addition,

the investment generates $70,000 per year for

shareholders, and that represents a 14% return on

their investment ($70,000 ÷ $500,000). It appears

> >

example

Suppose that a company has an investment project

that costs $1 million to undertake. Half of this

money will come from shareholders who require a

14% return, and half will come from bondholders

who demand 8%. In Chapter 5 we introduced the

concept of a company’s weighted average cost

of capital (WACC), a rate that blends the cost of

equity and the after-tax cost of debt. This is often

the rate that companies use to discount cash flows

in NPV calculations. If the company faces a 30%

corporate tax rate, then its after-tax cost of debt is

5.6% (8% pre-tax × [1 – 30%]) and its WACC is:

WACC = 50% × 14% + 50% × [8% × (1 – 30%)]

= 9.8%

Suppose that the company’s investment project will

generate annual sales of $440,000 in perpetuity, as well

as $300,000 in annual operating expenses. The company

must also pay $40,000 in annual interest expenses

($500,000 × 8%).^1 Is this investment worth undertaking?