Separation of Investing and Financing Decisions

We have already seen that there are a lot of differences that arise between what we have learned in accounting and how we use it in corporate finance. The separation of financing and investing decisions is one such important concept.

It is important because we have to make a very important adjustment based on this principle. That adjustment is the fact that we do not subtract interest costs while calculating the cash flows that a project will generate. This is different from accounting where we were used to subtracting the interest costs to calculate our income. So here we must remember that we have to exclude interest costs from our calculation. Failure to do so is one of the most common mistakes that are made by students.

Understanding What an Investing Decision and a Financing Decision Really Is?

When we take up a project, we really need to understand that we are making two decisions not one. The first decision is regarding the assets that we must invest in. This means that if we are opening up a restaurant we need to consider what the real estate would cost, what the improvements would cost to create the desired ambience, what the kitchen equipment would cost and so on. Then we must consider the returns that these investments will generate. This is the investing decision.

Now, the above investments could be done from spare cash that the company has, the company could sell more stock to raise the funds or they could even borrow to raise the funds for the project. How the company raises money for the project is an investment decision. Each of the above options has its own related costs. For instance debt will have interest cost, equity will have dividend cost etc. But that does not really change the cash flows of the project, does it?

The restaurant (investment) will generate the same returns regardless of how it is financed. Financing merely changes the people entitled to those profits. It does not change the amount of profits that are earned by the project.

The Procedure to Separate Investments and Financing Decisions

It is for this reason that we must first see the project without its financing costs to check whether it is viable. This simply means that the investment decision must be separated from the financing decision.

Once the viability of the project has been established, the company can then conduct a separate analysis to determine how the project needs to be financed. The company can check whether an all debt financing is better than using all of their own cash or whether a combination of the two is required. However, this decision pertains to capital structure and not to capital budgeting.

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