corporate finance (CFA level 1 )

chatterg11
Posts: 1
Joined: Mon May 30, 2016 5:32 am

corporate finance (CFA level 1 )

Postby chatterg11 » Sun Mar 26, 2017 6:35 pm

Please explain the fifth principle of capital budgeting. I am not being able to understand why we are not considering the financing cost specific to the project when estimating incremental cash flow?

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edupristine
Finance Junkie
Posts: 747
Joined: Wed Apr 09, 2014 6:28 am

Re: corporate finance (CFA level 1 )

Postby edupristine » Mon Mar 27, 2017 10:26 am

Hi Chatterg,

Financing costs are ignored.This may seem unrealistic, but it is not. Most of the time, analysts want to know the after-tax operating cash flows that result from a capital investment. Then, these after-tax cash flows and the investment outlays are discounted at the “required rate of return” to find the net present value (NPV). Financing costs are reflected in the required rate of return. If we included financing costs in the cash flows and in the discount rate, we would be double-counting the financing costs. So even though a project may be financed with some combination of debt and equity, we ignore these costs, focusing on the operating cash flows and capturing the costs of debt (and other capital) in the discount rate.


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