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Can you please explain why a loan and its repayment are not included as relevant positive and negative cash flows for project appraisal purposes. If a project is going to be financed by borrowing from a bank, those cash flows are future, incremental and will arise only if this project is implemented (so relevant). Although I must confess I am not sure about the economic meaning of a loan repayment discounted at WACC… On a separate note, thank you very much for your web site.
hi vort 24, i wish to try answer your question, by the way, anyone might correct me, if my answer is wrong, and appreciate to correct me.
the case is that, we do not include the loan interest and loan payment because loan interest already include in WACC (if the wacc you discounting is not only ke)
we put interest in wacc rather than display on cash flow appraisal table, because interest expense is a required return by debtholder. and wacc is the required rate of return by investor (shareholder and banker which provide loan to companyfor eg, project which are borrow $ 1,000 and interest rate annually is $ 100 (10%p.a)
while , your kd will be 10% , of course we need to calculate the tax saving of kd, so the kd (post tax will be ) 7 %, if the tax rate is 30 %. and for the principal, $ 1000, it is not consider incremental or cost for the project, because it will repay originally back to the debtholder. the cost will be the interest only.please correct me with clearly, if i explain incorrectly
adanliew: Please do not answer questions in this forum because it is the Ask the Tutor Forum and you are not the tutor (but please do help people in the other Paper AFM forum) 🙂
vort24: Essentially what adamliew has written is correct.
A loan and its repayment are not relevant cash flows. The only cost involved is the interest and the whole point of discounting is to account for the interest.I think it might help you understand this if you watch the Paper MA (was F3) lectures on interest and on investment appraisal.
Gentlemen, thank you for your quick answers, despite one of them being not in a relevant section (…talking about relevant things…:) I hope you don’t mind me giving this topic another spin.
As for the interest, this is clear to me, it is already included into the WACC or discounting rate etc. Good, let’s leave this behind. My question is about a loan and its repayment installments.
@adamliew: I am not sure the fact that a loan is supposed to be repaid could be an explanation, following this logic working capital should not be a relevant cash flow either. It is also fully returned at the end of the project (well, so we are told by the book).
@John: you mention that a loan and its repayment are not relevant cash flows, but why? I have watched your lectures but regretfully couldn’t find a section dealing with my question.a) if I plan to repay a loan from my project cash flows, I believe it is more than relevant to include these cash flows into the project assessment to see how the whole thing stacks up.
b) also, as related examples are usually something like “we want to buy another machine that will produce X items that will sell at Y price…” it is difficult to imagine project cash flows as something separate from general company cash flows. But let’s imagine for a second that we set up a separate legal entity to complete a capital project, which is not unusual for big projects, and we get a loan to start our project. Our (project’s) first cash flow transaction is not buying a machine, but actually getting cash into our account, so why is it excluded from the classic project evaluation methodology?
My only personal explanation I can loosely connect to the absence of loan/repayment cash flows is that after I have taken a loan, speaking generally, it becomes part of a total company cash pool, so it is kind of difficult to finger point which pound is for a particular investment project and which one is for settling accounts payable. So, this becomes a treasurer’s headache how and when we repay this loan while the project assessment in its pure form excludes these details. I can’t say it is very convincing but this is the best I can think about.
I apologize for my wordiness today.
sorry sir, i just want to know my answer is correct or not and it wont happen next time
adamliew: I have already written that what you wrote is true.
vort24: It is not mentioned in my AFM lectures because it is the most basic aspect of DCF calculations and has already been examined in Paper MA and Paper FM – to repeat all of MA and FM lectures for AFM would be ridiculous 🙂
Imagine I lent you 100,000 repayable in 4 years time and charged you no interest. It would not cost you anything and you could do whatever you wanted with the 100,000 during the 4 years.
Obviously I will charge interest and therefore the cost to you is the interest you are having to pay. When you invest the 100,000 in a project you therefore have to make sure that the returns from the project are sufficient to cover the interest cost. We check this by discounting. If the NPV is positive then it is more than covering the interest cost. If the NPV is negative then it is not covering the interest cost.
However the loan is repaid (whether interest is paid each year and the principal repaid after 4 years; or whether the only repayment is the principal plus interest at the end of 4 years; or any other repayment schedule) then the PV of the repayments will always be equal to the amount of the original loan – so to include them in the cash flows would make absolutely no difference and would simply achieving nothing.
Again, I explain exactly what is happening (and why) in my Paper MA lectures.
Dear John, thanks for all your answers.
to repeat all of MA and FM lectures for AFM would be ridiculous => I did watch your MA lectures and actually referred to them (not AFM) in my previous comment (because you referred to them in your original comment:)
When you invest the 100,000 in a project you therefore have to make sure that the returns from the project are sufficient to cover the interest cost => if you take a loan to implement a project, I think your primary concern is not so much the interest, but actually the principal repayment (as it is much more money and often specific time you need to do it), which is not reflected in the classic model
However the loan is repaid, then the PV of the repayments will always be equal to the amount of the original loan => this assumes there will be cash available to repay the loan on loan agreement specified dates, which in reality may or may not be true, and that is one of the biggest deficiencies of the classic model, I think
PV of the repayments will always be equal to the amount of the original loan => how are loan/repayments different from additional working capital requirements at the beginning/full return at the end?
I don’t know why you refer to it as ‘the classic model’ – there is no other model with respect to discounting.
We never consider that the repayment will come from the project in which they are investing. The company will be receiving money from all of its operations – not just from one particular project. When it comes time to repay then most likely they will raise more finance. That is of course assuming that the money is raised from debt and is not relevant if the money is raised from equity (although there is of course still a cost of the finance).
Obviously, of the money is raised by way of debt then they might not have sufficient money to repay – that is always uncertain but all the flows we use are by their very nature only estimates and are subject to uncertainty.
The primary concern of the financial manager and their most fundamental objective is to increase shareholders wealth, and all the techniques used stem from this.
Working capital has no connection whatsoever with any loan that may have been taken to finance the investment in the project. They need money at the start of the first year (i.e. time 0) in order (for example) to purchase inventory. They need working capital throughout the life of the project (and may quite likely need to increase the level of working capital during the projects life. At the end of the project the working capital is no longer needed, therefore (for example) the inventory remaining is used up in the final year which means lower expenditure on materials in the final year which we treat as an inflow.
Nowhere did I suggest watching all of the Paper MA lectures – only two of the chapters are relevant for Paper AFM. However all the discounting ‘rules’ and assumptions regarding project appraisal for Paper AFM are the same as for Paper FM (it is areas such as the capital asset pricing model, the management of foreign exchange risk and interest rate risk that are expanded considerably in Paper AFM). The basic ‘rules’ for investment appraisal are regarded as being fundamental and you are not asked to justify them in the exam.
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