Challenges of Risk-Based Supervisory System
In the previous articles, we have studied what a risk-based supervisory system for pension funds is. We have also studied the various steps which need to be taken in order to set up such a system. It is true that this system is being adopted on a large scale worldwide because of the various benefits […]
Municipal Bonds
We already know that bonds are issued by a wide variety of entities. Bonds are routinely issued by corporations, banks, and even governments all over the world. A special category of bonds called municipal bonds (munis) are issued by various local governments across the globe. These bonds are often categorized separately because they have certain […]
Personal Financial Statements
It is common practice for businesses to prepare financial statements. This is because they need to get these financial statements audited. Once these statements are audited and found to be correct, they become an official record that can be used in loan applications as well as for tax purposes. However, since individuals do not need […]
Causes of Shrinkage in the Retail Sector
In the previous article, we have already understood the concept of shrinkage. We now know how shrinkage is calculated and are also aware of the financial impact that it has on retailers. It is a known fact that shrinkage cannot be reduced to zero. It has to be brought under control. Retailers have been streamlining […]
What is Accounting? – Meaning and Important Concepts
Accounting has been hailed by many as the “language of business”. There are many quotations like “A pen is mightier than the sword but no match for the accountant” by Jonathan Glancey which tell us about the power and importance of accounting. The text book definition of accounting states that it includes recording, summarizing, reporting […]
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.
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.
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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