Why Capital Budgeting Usually Separates Operating Cash Flows from Financing

# Why financing costs are ignored in capital budgeting of projects?


# Why financing costs are ignored in capital budgeting of projects?












Any finance textbook I have encountered including CFA materials states something like this:

- "Financing costs are ignored. This may seem unrealistic, but it is not. Most of the time, analysts want to know the after-tax operating cash flows that result from a capital investment. Then, these after-tax cash flows and the investment outlays are discounted at the “required rate of return” to find the net present value (NPV). Financing costs are reflected in the required rate of return. If we included financing costs in the cash flows and in the discount rate, we would be double-counting the financing costs. So even though a project may be financed with some combination of debt and equity, we ignore these costs, focusing on the operating cash flows and capturing the costs of debt (and other capital) in the discount rate." Taken from CFA currirulum.

- I have hard time understanding how reasonable it is both from practical and theorical approaches.

- In valuing Fixed Income securities such as bonds, the interest payments are considered cash flows even if they are then discounted at some applicable discount rate, which is also a product of how market calibrates the interest and principal payments and the timing of those. A subsequent logical question which arises is the following: how valid is the argument of "not double-counting" in capital budgeting projects if according to this argument we also double count in the theoretical framework for the bond valuation.

## Answer by RaveTheTadpole (score 4)

https://quant.stackexchange.com/a/45667

I think the textbooks are suggesting that most capital budgeting doesn't explicitly include the mechanism of financing for a specific project. Instead, the planners would use some overall average corporate cost of capital, and the details of actually coming up with the money are left to the Treasurer. In these cases, financing costs are part of the hurdle rate (aka the required rate of return). It is a shortcut for handling smaller projects without getting into the financing details.

If a project was so large that it would require specifically-tailored financing, and such financing can be understood well enough that its cost can be appropriately estimated, then those project-specific costs could be used in the model instead. In this case, we would expect the project to be wrapped in its own entity, isolating it from any parent business, and any financing for the subsidiary would be priced on the merits of the project itself. Which is a market-driven way of determining the project-specific required rate of return.

As for bonds, I'm not understanding your argument/confusion. The bond is designed to have a specific coupon rate, often chosen to be approximately the prevailing interest rates at the time of issue, but this is arbitrary. Once designed/issued, these future nominal payments (the coupons and the final principal) are fixed. When valuing the bond at some future time, we discount those fixed future dollars by an appropriate discount rate for the credit quality and tenor of each payment. This appropriate discount rate will fluctuate over time, and so the fixed dollar payments result in changing present values... i.e. changing price of the bond. There is only a single discounting going on, and it's during the valuation process.

## Answer by Yan (score 0)

https://quant.stackexchange.com/a/69159

Simple because you want to measure the operating profitability of the project and therefore exclude all financing questions. The financing question (loan versus equity) will be sold if the project is selected.