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Dear Tutor!
I am going through the Kaplan study text. Underneath “assumptions used in discounting,” it reads:
“Also, note you should never include interest payments as cash flows within an NPV calculation as these are taken account of by the cost of capital.”
What is the logic here ?
Why should we not include interest payments? What does it really mean that it is taken care of in cost of capital? I just assume that the cost of capital percentage given in any question means the interest rate. What does it really mean?
Thank you very much !
The cost of capital is usually a weighted average “cost of capital” because most businesses are financed by various sources of finance. They don’t always take out a new loan for a project.
So if you think a company could have 40% Debt (Interest) 10% (Pref) and 50% (Equity)
The WACC would be say 0.4 * 5% , 0.1 * 10% and 0.5 * 12%
So it will be 9% cost of capital (WACC)You will see all of this in later lectures on the cost of capital – how to calculate the costs as a % and the market values. That is what I have used for the proportion.
So if you include interest in the NPV you would be effectively double counting!
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