Any finance textbook I have encountered including CFA materials states something like this:
- “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.” Taken from CFA curriculum.
- I have hard time understanding how reasonable it is both from practical and theoretical approaches.
- In valuing Fixed Income securities such as bonds, the interest payments are considered cash flows even if they are then discounted at some applicable discount rate, which is also a product of how market calibrates the interest and principal payments and the timing of those. A subsequent logical question which arises is the following: how valid is the argument of “not double-counting” in capital budgeting projects if according to this argument we also double count in the theoretical framework for the bond valuation.