I’m a bit confused with the capital budgeting section. I’m aware that financing costs have to be ignored in order to calculate NPV, otherwise they would be double counted because financing costs should already be reflected in the discount rate. So how do you analyze the impact of different financing options, for example, if I finance 90% of the project at 8% interest or 75% at 9%, etc? I don’t understand the logic behind ignoring the financing cost because I would think that how much of the project is financed is also important. However the book says that how you finance the project is irrelevant to calculate NPV, but that’s not what I’ve noticed in practice. My other question is where is the financing cost in the discount rate. To find the NPV of a particular project we cannot use the WACC, the correct discount rate is calculated using CAPM or APT. Let’s say we use the CAPM, is the financing cost included in the beta?
I agree, this is an area that presents some confusion. A few notes on your post…you say “how much of the project is financed”. The entire project is financed. The question is whether that financing is coming from debt or equity. I always assumed that the calculation of the project’s beta would somehow incorporate these costs through the estimation of the project’s risk, but I offer no explanation as to how that is actually quantified.
You’re right, it is financed with either debt or equity, but my main concern is how to measure the effects of financing with both at the same time (50/50).
The key principle is that the project is discounted at a rate that reflects the riskiness of its CASH FLOWS, not the riskiness of the firm. If the project were of the same risk as the company as a whole, you’d use the cost of capital. The reason for this this is that if an investor were to buy all claims of the company, he would recieve all after-tax cash flows of the company. He would also require the weighted-average after-tax return on those securities. Note: If he were buying all the securities of the firm, he would receive the free-cash flow to the firm, which is a before-financing cash flow. Of course, if the project is riskier than the average project of the firm, you would use a HIGHER discount rate. If not, you would “over-accept” (i.e accept project that appear to be profitable using the incorrect rate, but would be negative NPV using the correct (higher) discount rate). If the project is less risky than the company’s average project, you have the opposite problem (if you don;t use a lower discount rate to reflect the lower risk, you’ll reject project that should be accepted).
So how do you work through a problem with 80% debt? Do you ignore the reduced initial outflow of 20% and exclude financing costs? Or do you ALWAYS have to work out the problem as if you were financing the project 100% equity?
busprof gave an excellent explanation. don’t worry about debt. it’s going to be reflected in WACC calculation. Then WACC will be adjusted for risk to come up with the appropriate discount rate.
Ok, just so I’m clear then… If you run different scenarios with different levels of debt and interest rates, this will have no impact on IRR? NPV will change because of the different project WACC in the different scenarios.