Interest Expense In Capital Budgeting

CFA Level II Corporate Finance
#1

Hi, I’m a level two candidate but I feel like I need some real expertise and work experience for this question. And I appreciate your help!

I’m having some real trouble understanding two principal in capital budgeting

  1. Cashflows are based on opportunity cost.
  2. Interest expense is excluded from cashflow, otherwise, we would be double counting.

  • Can someone give me an example of an opportunity cost that should be included in real life? I’m thinking along the lines of, if have 100k and undertake project A, what I’m missing out on project B should be included as an outflow for my cashflow assumption?

  • My bigger trouble is with the interest expense being ignored… I mean holy cow. Let’s say I burrowed 100K interest-only loan from the bank at 10% for my real estate investment. Do I exclude the 10K I pay out in interest every year? If this is the case, all the NPV and IRR analysis I’m doing for my job are all incorrect, and I work for a publically traded REIT firm and they gave us the model. My second thought is that maybe this concept is referring to implicit interest cost at 10% should not be included.

I would appreciate it if someone can give me a response on this. Thanks!

#2

Opportunity cost is basically the foregone benefit. For example, say that you have a factory you are using to produce widget A and you make 1 million per year producing and selling them. However, you have an opportunity to produce Widget B but you need to use the same factory (this assumes that you stop producing and selling widget A). You know that with widget B you can make 1.5 million per year. The foregone benefit is 1 million because you stop producing and selling widget A but you also gain 1.5 million by producing and selling widget B so you net CF including the opportunity cost is 500k. So when you make your capital budgeting analysis, your CFs would be $500K NOT 1.5 million.

As for the interested expense, assuming the WACC is used, you are already including the interest in your cost of capital. Deducting interest to get your CFs would thus mean that you are double counting interest expense. Concerning your scenario, what is the discount rate you are using? If you simply use cost of equity then I think you are ok to deduct interest expense but if you use the WACC interest expense should never be deducted to arrive at your CFs.