Question

You are part of a team that is determining whether your company should undertake a new project. Your team calculated the NPV of the new project using the cost of capital (weighted average cost of capital) to discount the future cash flows. However, the Chief Financial Officer noticed that your team excluded the interest payments in estimating the future cash flows.

Discussion Questions:

1. Why did your team exclude interest payments in the estimation of future cash flows of the new project? Explain.

2. What method should your team use to evaluate the feasibility of the new project if the Chief Financial officer insists on including interest payments? Be detailed in your response.

Answer 1

Question 1

We have not considered the finance costs because we are discounting the cash flows at weighted average cost of capital. Since Weighted average cost of capital includes the impact of such interest expenses and be recovered from there in , we need not to consider interest expenses. When we are using Weighted average cost of capital , it means we are recovering the cost of investment from the perspective of both Equity holders as well as Debt instrument holders. That is why , we have not considered the interest expenses in cash flows.

Question 2

If we were to consider interest payments as an outflow , then we should discount such future cash flows at cost of equity ( which is relatively more than the Weighted average cost of capital) . The reason behind this is that if we discount at cost of equity , we have to consider only the return that will be available to Equity shareholders. We need to consider the interest payments in cash flows but not in the recovery( ie., rate of discounting).

Hope this is clear and ALL THE BEST