Question

1. If the firm knows in advance that a project will be financed by a bank loan and that the cash flows from this project must cover the payments to the bank, would financing become a parameter in the capital budgeting decision? Why or why not?

Answer 1

Yes, financing will still become a parameter in the overall capital budgeting decision because even if the company is knowing that the project will be financed by Debt capital, the company will have to ascertain that a large amount of cash flows would be generated which would be helpful in order to cover the interest expenses of commercial banks and it would be able to repay them so that there would not be any cost of financial distress.

Capital budgeting decision is not just related to financing of the project but it is also related to covering of the cost of the capital and generating of enough amount of cash flows in order to satisfy the payments schedule so that these project will be resulting into a overall profit for the company.

So it can be said that financing would still be a factor in determination of overall capital budgeting decisions as it would also be leading to do a comparison between the the interest tax benefits resulting out of tax deduction, and the cost of financial distress which are to be balanced, and the large amount of cash flows which are to be generated which will be beating the cost of debt in order to add the profit to the company.