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CS Professional · Strategic Management and Corporate Finance · Project Evaluation

Which statement about financing costs in estimating project cash flows for NPV analysis is correct?

Interest is excluded from project cash flows because the financing cost is already reflected in the discount rate, the cost of capital. Deducting interest in the cash flows too would double count it, and dividends are likewise not project cash flows.

  1. AInterest on the loan used for the project is deducted from operating cash flows, and the discount rate is also the cost of capital
  2. BInterest is excluded from the cash flows, as the financing effect is captured in the discount rateCorrect
  3. CInterest is added back and then discounted at the risk-free rate
  4. DDividends paid to shareholders are deducted from project cash flows

Explanation

Cash flows are estimated on an unlevered basis, before financing charges, and discounted at the cost of capital which already reflects the cost of debt and equity. Deducting interest as well would double count the financing cost.

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