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 8)
Institute, CFA. 2016 CFA Level I Volume 4 Corporate Finance and Portfolio Management. CFA Institute, 07/2015. VitalBook file.
The citation provided is a guideline. Please check each citation for accuracy before use.
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?
In relation to your latter point, just to make sure I got it straight… the payback period as described in the curriculum is basically inaccurate since it leaves out financing costs (as well as having other shortcomings mentioned in the text)? If you didn’t point this out, I wouldn’t have noticed this deficiency. Thanks for that.
I’ve never heard anyone else mention that subtlety about payback period.
There’s also a subtlety about discounted payback period: when calculating the whole years to get to the payback period, it assumes that the cash flows occur at the end of each year, but when calculating the fraction of the last year, it assumes that the cash flows occur evenly throughout the year. In short: it’s internally inconsistent.
Neither of these will appear on the exam, but they’re good to know as they demonstrate that you really understand these (rotten) measures.
I don’t quite understand the problem you are describing.
At the end of year 4, there was -$245.2 outstanding. At the end of year 5 there is $686.18 in the kitty. So taking $245.2/$931.38 gets you 0.26 years. But where is the problem? More specifically, if this is wrong, what is the right way?
The problem is that when we discounted the year 5 cash flow we assumed that it all occurred on December 31: so we were in the hole $245.20 for the entire year, then BAM!, on December 31 we’re $686.18 to the good… Saying that we break even 0.26 years into year 5 says that we break even at the end of March. So which is it: did we get all of the cash on 12/31, or did we get 26% of it by March 31?
Yep understand that this isn’t going to be examined but still good to know.
Ah, I think I was approaching this from the wrong end. I was playing around with discount rates, breaking down the year into months etc and trying to find a breakeven point.
I think what you are saying is that it’s as simple as the fact that your cashflow estimates for the NPV analysis are done on a yearly basis in this case, but suddenly your payback period is not being consistent and giving you an answer that doesn’t gel with the actual estimated cash flows periods. So realistically, your payback period in this case is simply 5 years.
Overall, yes this is a very rough measure of project performance and I guess in the real world, it’s only ever calculated on a napkin to quickly gauge a project and determine if further analysis is warranted (bearing in mind its deficiencies).