Reading 31: Capital Budgeting Question 3

[boston_level2_c]

3. When assembling the cash flows to calculate an NPV or IRR, the project’s after-tax interest expenses should be subtracted from the cash flows for:
1. Both, NPV and IRR
2. Only NPV
3. Only IR
4. None of them.
Well, the way that I look at it, the CFO is = (S-C-D)(1-TR%) + D. To calculate the NPV, you need 3 different cash flows: Initial outlay, annual after-tax operating cash flow, and terminal after-tax non-operating cash flow.
I believe that the interest expense (which is a “S” in the above equation, since it is an operating cash flow and a tax-deductible cash charge, is used in calculating the CFO, and hence, the NPV.
However, the answer to this question is (4) None of them.

 

[Black Swan]

It’s 4. None of them because the interest expense is usually a component of the required rate of return and is taken out during the discounting process, not at the initial cash flow level. I may have done a poor job explaining it, however answer 4 makes sense to me, maybe someone else will do a better job and clarify it for me as well.

 

[achogogo]

S is sales and c is cost and the equation: (s-c-d)(1-T)+D or (s-c)(1-t)+td has nothing to do with interest expenses.

 

[clama]

achogogo is correct … (s-c-d)(1-T)+D or (s-c)(1-t)+td is nothing more than operating income or EBITD … hence it is before int exp is accounted for.

 

[busprof]

The reasons you don’t include interest are:
1) In an NPV, the interest rate is a component of the WACC. Were you to deduct interest from cash flows and then discount at WACC, you’d in essence be “double counting” the interest.
2) In an IRR, the interest rate is also embedded in WACC. You compare WACC to the IRR caclulated based on the cash flows of the project. So, once again, if you deducted interest costs from cash flows and then compared the resulting IRR to your WACC, you’d be double-counting the interest again.
In either case (NPV or IRR), deducting interest costs from CFs would result in you “over-rejecting” projects (i.e. some projects that you’d accept under the correct method would be rejected if you incorectly deducted interest).

 

[Black Swan]

That’s what I was getting at but didn’t want to specifically mention WACC as the discount rate or hurdle rate can be set arbitrarily and doesn’t necessarily have to be WACC although it usually is.