Question

Why are interest charges not deducted when a project’s cash flows for use in a capital budgeting analysis are calculated?

Answer 1

While evaluating a capital expenditure proposal, we take the investment financed by both equity and debt. That means we calculating the NPV value for total investment but for equity alone. So cash flows used for discounting should be those belonging to both debt and equity should be considered. In otherwords, we presume single line of finance at WACC ( weighted average cost of capital ) rate of interest for the funds borrowed.

when we are discounting the cash flows using WACC as the discount rate, you can clearly observe that cash flow after multiplying with dicounting factor of the year gets reduced. Thus we are indirectly deducting WACC as a cost of capital ( Interest ) from each year cash flow.

Thus deducting the Interest charges again cannot be allowed. Above two cases presents the reasons for not considering the Interest charges while calculating the annual cash inflows.