Hi all,
Can someone please explain why in capital budgeting financing costs are ignored because according to the book “financing costs are reflected in the required rate of return.” ?
E.g. How can interest payments, financing fees and salaries of the personnel required to complete the financing process all be included in the required rate of return?
An example would be great 
many thanks!
Any periodic payment (like interest) are already captured in the cost of capital. “One off” financing costs like flotation costs (and, I’d assume salaries of personnell) would be recognize as cash flow items.
Here’s why you don’t include things like interest payments in cash flows. The interest payments are captured in the cost of debt (and by extension, in WACC). As far as NPV calculations go, if you decreased cash flows by interest and then further discounted them using WACC, you’ve essentially double counted them (once in the cash flows, and once in WACC). This would cause you to “overreject” projects.
Likewise, in an IRR calculation, if you decreased cash flows for financing costs and then compared the resulting IRR to WACC (which also caputes these costs), you’ve once again “double counted” the costs, and will overreject.
At the other extreme, payback period doesn’t even consider financing costs once.
S2000 -I was limiting myself to the DCF-based measures (IRR. NPV, PI).
I understand.
I just find it interesting that CFA Institute makes the broad statement that we don’t include financing in the cash flows for a project because those costs are included in the discount rate, then teaches a method that includes neither financing cash flows nor a discount rate.
Thanks guys, getting a better idea now
Cool!
You could also argue that the principle is that the cash flows should be independent of the financing - strictly resulting from asset-side and operating cash-flow effects. At least, that’s what I tell my class (Although CFAI violates that principle when including flotation costs in the project’s cost).
Not including financing costs in cash flows would also make the cash flows consistent between Payback and Discounted Payback.
aaaaaannnnnd back to S2000.
I have the same problem of understanding this concept where the financing costs are accounted for (i.e. subtracted) in the required rate of return when discounting the incremental afer tax cash flows of a project - only I’ve gone through all threads on this forum related to this topic but just couldn’t find an explanation that would demystify this so I can properly understand it.
Basically, we use TVM and discounting in order to account for the difference in value i.e. having 100 dolars today is the same as having aprox. 160 dolars in 5 years time because you can take these 100 dolars today, put it in the bank at say 10% interest rate and you will have this amount of money in 5 years time.
Now, back to capital budgeting. We take some incremental after tax cash flows and discount them at a required rate of return of say 12%. When we do this, we account for the TVM of money using a discount rate which has components of required debt and equity return, i.e. the investor/company wants to see what is the value of the project today using a discount rate considering the preferred return.
Ok… but where in this story are the financing cost accounted for/subtracted from these project cash flows?
The only way I can explain this to myself so that it makes sense is to use the same perspective as for the EV calculation where we do not subtract financing cost (interest outlows) when calculating FCFF because EV includes the value of total assets of a company - financed by both the lenders and the shareholders. So, capital budgeting for a project is done from the perspective of the company as a whole (both lenders and shareholders) and, therefore, these financing costs are not excluded.
Is this true or not and what am I missing out on?
Please help