Thursday, June 10, 2010


Financing Effects in Investment Evaluation

In our discussion so far, we have ignored the question of financing an investment projects in the computation of new cash flows. We have implicitly assume that the firm undertaking the project is a pure-equity financed firm and therefore, the project is sub just only to business risk. The opportunity cost of capital as the discount rate reflects the business risk of the project. Hence the net present value of the project does not include the financing effect.

A firm in practice may finance an investment project either by debt or partly by debt and partly by equity. How should we treat the financing effects in the investment evaluation? Should the proceeds of debt and equity and payments of interest, dividends and principle be considered in the computation of the investment’s net cash flows? According to the conventional capital budgeting approach in which the discount rate is adjusted for financing effects, cash flows should not be adjusted for the financing effects. The firm should not treat the debt and equity proceeds as the investment’s inflows nor should it recognize payment interest, dividends and principle as outflows. Thus, unlike in the computation of the accounting profit, the net cash flows of an investment do not incorporate interest charges and their tax shield. The net cash flows are defined as the free cash flows and calculated as follows:

Delta NCF = Delta EBIT (1 – T) + Delta DEP – Delta NWC – Delta CAPEX

The adjustment for the financing effects is made in the discount rate. The firm’s weighted average cost of capital (WACC) is used as the discount rate. When we discount an investment’s free cash flows by the weighted average cost of debt and equity, we are in fact ensuring that the investment yields enough cash flows to make payments of interest and repayment of principle to creditors and dividends to shareholders. It is important to note that this approach of adjusting for the finance effect is based on the assumptions that:
  • The investment project has the same business risk as the firm.
  • The investment project does not cause any change in the firm’s target capital structure.

These assumptions may be valid for small projects, but not in the case of large projects, which may have different business risk and debt capital.

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