Why does an adjusted net present value analysis treat the present value of financial side effects as a separate item? Isn't interest expense a legitimate cost of doing business?

Question

What will be an ideal response?

Answer 1

The adjusted net present value approach to capital budgeting starts by valuing the free cash flows to the all-equity cash firm. It then adds other sources of value associated with how the firm is financed. As in the weighted average cost of capital (WACC) approach in Chapter 16, the numerator cash flows are the free cash flows to the all equity firm. In contrast to WACC analysis, which discounts these cash flows with a discount rate that is a weighted average of the after-tax required return on the debt and the rate of return on the levered equity, the ANPV analysis uses the rate of return on the unlevered assets to get the all-equity value. Students sometimes think that the deductibility of interest as a business expense is therefore missing, and they want to reduce the all-equity free cash flows by the after-tax interest payments. This misses the fact that the value of the interest tax shields is being added as a separate source of value in ANPV, whereas it is included in WACC. Also, it misses the fact that when the equity holders lever the firm, they get the principal on the debt up front and don't have to put as much equity into the firm for its investments. The present value of the future cash outflows for interest payments and repayment of principal equal the initial value of the principal, in which case it is only the tax shield that needs to be valued. ANPV does this separately.