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Matching Project Cash Flows and Discount Rates in Debt-Financed NPV

Article Quant Q&A · Author: NewStudent
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Summary

The document distinguishes two ways to evaluate a project when debt financing and repayments appear in the cash-flow model. Free cash flow to the firm includes cash flows available to both debt and equity holders, so it is discounted using the weighted average cost of capital. Free cash flow to equity includes only cash flows for shareholders and is discounted using the cost of equity.

For the question’s case, where loan payments remain in the cash flows, the answer says to include the debt funding received at the start as well. The initial project outflow is offset by the borrowing, leaving no net initial cash flow to equity in the stated example. The resulting stream is treated as equity cash flow and paired with the cost of equity. This is a concise conceptual answer; it does not develop a full NPV calculation or discuss tax treatment and financing assumptions in detail.

Key ideas

  • Free cash flow to the firm includes amounts allocated to both lenders and shareholders.
  • Free cash flow to the firm is discounted using the weighted average cost of capital.
  • Free cash flow to equity is discounted using the cost of equity.
  • If debt proceeds and repayments are included, the initial debt funding should also appear in the cash flows.
  • Cash-flow definitions and discount rates must be consistent.

Tags

Fixed incomeRisk management
Full text
# Inclusion of loan payments in NPV and tax benefits


# Inclusion of loan payments in NPV and tax benefits












I have queries on proper estimation of NPV in the context of debt repayments and associated tax benefits of interest payments. This question tries to build up on the previously asked question (Why do not include loan payments in NPV?) about deducting the loan repayments from the operating profit. The accepted answer in the cited question seems to suggest that both principal and interest payments can be deducted. However, the answer goes on to use the investment amount as only the equity amount for the NPV calculation (Example 2).

If I start the project with only debt, is the above calculation correct in attached image with $C_0 = -150$ ? I have reduced the entire loan repayment (PMT function from MS-Excel) from the gross profit.

Moreover, what should be the appropriate cost of capital ?

These queries seem fundamental to the concepts of WACC, cost of debt and NPV. I would be grateful for your help to understand these concepts. Please advise.

## Answer by stanley (score 0)

https://quant.stackexchange.com/a/83889

Free cash flows to firm (FCFF):

- cash flows to be further allocated between equity and debt holders.

- weighted average cost of capital (WACC) is an appropriate discount rate.

Free cash flows to equity (FCFE):

- cash flows to equity holders only.

- cost of equity is an appropriate discount rate.

In your case, if cash flows from/to debt holders are retained in the model, day-0 funding from debt holder should be added also. i.e., Day 0 cash outflows = -150 to the investment project + 150 from the debt holder = 0

The cash flows are FCFE and cost of equity should be used, instead of WACC.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.