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Hello,
I am currently checking one of the suggested answers of ACCA for past exams. According to model answer, interest payable on the loan should not be included as a separate cash flow item in NPV calculation since it is part of the financing decision and is included within the discount factor. However, if interest costs are included in the cash outflows, the equity cost of capital, not the weighted average cost of capital, should be used in the computation.
I gues I did not understand well this explanation. Does it say, when you use weighted average cost of capital, it already includes interest cost. But if you use equity cost of capital( perhaps lower, not reflecting interest cost) we should included interest cost separately. Is my understanding correct?
Thanks
WACC is a mix of the cost of loans and the cost of equity. The cost of equity takes account of dividends and the cost of loans take account of interest. Therefore, when using WACC neither interest nor dividends should appear in the cash flows.
If there are both equity and loans in a company’s finance, WACC should be used as the discount rate. It is usually regarded as incorrect to match a specific type of finance to a project as, long-term, the WACC will stay about constant. To match finance to projects is an accident of timing.
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