I’m trying to figure out this in relation to capital budgeting:
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.
Institute, CFA. 2016 CFA Level I Volume 4 Corporate Finance and Portfolio Management. CFA Institute, 07/2015. VitalBook file.
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Specifically, I’m trying to figure out why capital budgeting prefers to account for financing costs in the discount rate and not by simply accounting for this in the cashflows and then discounting by the risk free rate + inflation or whatever the appropriate discount would need to be? Why not simply add all the cash inflows from things like revenue and subtract all cash outflows like dividends and interest?
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