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CA Final · Advanced Financial Management · Advanced Capital Budgeting Decisions

Which statement about treatment of interest and financing flows in estimating project cash flows for NPV is correct?

Interest is left out of the project cash flows because financing cost is already reflected in the discount rate, usually the WACC. Deducting interest as well would double-count the cost of funds and understate the NPV.

  1. AInterest on debt used to finance the project is deducted from operating cash flows and then discounted at the WACC
  2. BInterest is ignored in cash flows because the financing cost is captured in the discount rateCorrect
  3. CInterest is deducted only for the tax shield and the principal repayments are included as outflows
  4. DInterest is included in cash flows and the discount rate is the risk-free rate

Explanation

In the standard NPV approach, cash flows are estimated before financing charges and discounted at a rate (WACC) reflecting the cost of funds. Deducting interest as well would double-count the financing cost. The tax shield on interest is also reflected via the after-tax cost of debt in WACC.

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