Question

When a firm finances a new investment, it often borrows part of the funds required, so the interest and principal payments this creates are incremental to the project’s acceptance. Why are these expenditures not included in the project’s cash flow computation?

How does a firm’s use of short-term debt as opposed to long-term debt subject the firm to a greater liquidity risk?

Answer 1

When the firm is financing a new investment, then the interest payments are not included in the project cash flow computation, because interest payments are always considered as non operating form of expenses and since borrowing of money does not lead to increase in the operating income, the interest payment should not be leading to decrease in the operating income so the cash flows resulting from interest of the project should not be considered in the project cash flow computation.

Firm use of short term debt as opposed to long-term debt, will subject the firm to a greater liquidity risk because the firm will have to repay there short term debt in quicktime and it needs to have a higher amount of cash in its books in order to repay those debt obligation, else the firm can default on its debt payments and it will lead to a cost of financial distress and it can even put the firm into insolvency, because that debtholders can enforce their collateral.