Interest expense and capital budgeting

Can someone explain to me why interest expense is excluded from the capital budgeting process?

I understand the textbook explanation is that this is essentially double-counting, but can someone please illustrate a real-life example?

If my firm is financed 100% on debt for a total capital amount of 100, and my cost of debt is 10%, I would be paying interest of $10 every year. Let say my project generates a year 1 and year 2 free cash flow of 100,000. I would still be obligated to pay the interest of $10. But if I discount my entire 100,000 cash flow by 10% using wacc, it is saying that my debt obligation (cost of debt) would be 10,000. How does this make any sense?

I am struggling so hard on this concept.

You are valuing the project (i.e. asset side), so you need to compute the after-tax operating cash flow of the project minus capex (this is similar to FCFF Model in Equity).

Why do we not deduct interest expense?

When you compute the after-tax operating cash flow (ATOCF), the ATOCF is the cash flow available for distribution to debtholders and shareholders. That’s why we also discount the project cash flows with WACC (numerator and denominator are consistently linked to debtholders and shareholders).

1 Like