Question #9 Capital Budgeting - Corporate Finance

CFA Level II
#1

Hello,

I could not figure out why after tax interest expense would NOT be reduced when inflation is lower than expected.

Specfically, I do not understand how the WACC formula (which incorporates after tax interest expense) takes into account inflation.

I thought after tax interest expense was based fixed interest payments?

Thanks,

#2

Interest payments are the interest expense, it is fixed. Why would interest payments vary if your debt has not varied?

WACC rate incorporates _ expected inflation risk premiums _

#3

you need to realize what it is you need to solve a question

usually the item set will contain way more information than is needed. … and if you use the wrong information, you will find definitely an answer that is designed to make you use the wrong inputs …

so you

a) need to know the material well

b) decide what information you need to use to solve the question

and

c) develop speed reading skills –

go to the questions first

read the question

understand the portion up to which you have to read the item set to solve the question

and use the information appropriately to answer the question

====

to build these skills keep the 18 min to both read the item set and to answer the 6 questions as a guideline to help!

#4

Maybe I am then confused on when the text says that we do not subtract interest expense (only subtract cost of the project and deprecation expense from the project revenue) for the operating cash flows for a capital project because the WACC already incorporates interest expense (via the cost of debt portion of the WACC formula).

But here, we are talking about interest payments to bondholders by the company. Are these two different issues?

Thanks,

#5

We do not include interest expense in operating cash flows for evaluating a project because we assume no debt is involved. The idea is to asses how much profitable is the project inherently. If you find the project is good enough for investment in an stand-alone basis, then we can improve its profitability by structuring a debt on the project (as long as the after-tax cost of debt is cheaper than the IRR of the project).

#6

Sounds good. Does this question then assume that the value of after tax interest expense is increased, because the value of the payments to the bondholder had increased (with a lower level of inflation)?