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Three treatments of debt financing for capital budgeting decisions.

Three business school disciplines--accounting, finance, and real estate--make use of the capital budgeting concept when teaching project decision making. Capital budgeting has been defined similarly in each discipline as, "The process of planning expenditures on assets whose returns are expected to extend beyond one year."(1) Data used in capital budgeting analysis are based on cash flows generated from the projects. In determining these cash flows each discipline utilizes "only the incremental, or differential, after-tax cash flows that can be attributed to the proposal being evaluated."(2)

Despite the clarity of these definitions, each discipline appears to differ markedly over the treatment of debt financing and interest expense in projecting cash flows for capital decisions. An investigation of existing texts shows that a number of differences exist in the treatment of debt for capital budgeting purposes in each discipline. These variations appear to have developed as a result of the way debt is considered to fund business projects. The way these inconsistencies arise in the literature and how these differences may be resolved are examined here.

The accounting emphasis on the attest function and objectivity leads to a distinction between recording income for reporting purposes and using cash-flow information for capital budgeting decisions. Financial managers who use pricing from a capital asset pricing model (CAPM) are constrained to separate the investment decision from the methods of financing in considering capital projects. Real estate professionals appear to embrace a holistic view of the capital budgeting decision that incorporates financing and investment issues.

In light of the altogether differing applications of capital budgeting in accounting, finance, and real estate, it may not be surprising that each discipline varies in its treatment of debt financing. What may be significant, however, is the lack of information in undergraduate business texts on these alternative views. Students taking courses in finance are unlikely to be aware of the varying uses of debt financing unless they take additional classes in accounting or real estate. Similarly, those who major in either accounting or real estate would have to take course work in areas outside of their discipline to be exposed to any discrepancies in the use of debt financing for capital budgeting decisions.

A synopsis of the way interest expense is treated in the capital budgeting process in finance, accounting, and real estate is presented in this article. How these differing views may lead to conflicting capital budgeting decisions is then examined. This investigation concludes with a summary of how these alternative views may be reconciled for undergraduate business students.


The finance view treats debt and interest expenses in capital budgeting as if the projects were 100% equity financed. Consequently, finance text authors render interest expense as an irrelevant cash flow in the capital budgeting process. Some finance authors advance the interest irrelevancy point of view while arguing that any debt financing on capital projects may be implicitly included in discounted cash flows (DCF) using the weighted cost of capital. The following examples serve to illustrate the view of interest expense now prevalent in finance texts:

We would not subtract the debt proceeds from the required investment, nor would we recognize interest and principal payments as cash outflows. We would treat the project as if it were all equity financed.(3)


Most firms do use debt and hence finance part of their capital budgets with debt. Therefore, the question has been raised as to whether or not interest charges should be reflected in capital budgeting cash flow analysis. The consensus is that interest charges should not be dealt with explicitly in capital budgeting--rather, the effects of debt financing are reflected in the cost of capital which is used to discount the cash flows. If interest was subtracted, and cash flows were then discounted, we would be double counting the cost of the debt.(4)

Based on this perspective, a typical capital budgeting problem in finance would exclude interest expense in computing net cash flow. In addition, the amount of initial outlay would typically include the total cost of the asset(s), plus installation costs and training expense, regardless of how much these costs may have been financed with debt. For example, if the purchase price of an asset were $12,000, then that would be the initial outlay used in the capital budgeting analysis, irrespective of how much was borrowed to finance it.

The rationale for this approach is that it separates the investment decision from the financing issues related to accepting or rejecting capital projects. The assumption is that the investment decision is unaffected by financing arrangements. If the investment appears attractive, it remains advantageous independent of the way it is funded. To some extent, the separation of financing from the operational aspects of capital budgeting decisions rests on the notion that capital structure is unimportant in the selection of projects.

Table 1 provides an example of how a capital budgeting problem is formulated in finance. In this illustration, the entire cost of the asset(s) including installation, training costs, and required net working capital (NWC) is shown as an initial cash outflow ($26,000). The method of financing the project does not explicitly enter into the analysis. Interest expense is not included as an outflow. The discount rate used in Table 1, however, is based on a weighted average cost of capital for the firm of 12%, and implicitly uses the after-tax adjusted component cost of debt. The net present value (NPV) from these cash flows is $617.19 and the internal rate of return (IRR) is 12.88%. If the firm's weighted average cost of capital were reduced to 10.275%, then the NPV would be $1,889. At this rate, the finance view would produce an NPV equivalent to the one calculated via a real estate approach TABULAR DATA OMITTED to capital budgeting. At the lower weighted average cost of capital, the firm's interest rate on new debt would have to decline to 8.81%. Table 1 assumes that the firm pays 20% of the initial outlay for the project and finances the rest. The financing issue is not relevant under this method, however, and so interest expenses are left out of the cash flows and the entire cost of the project is included in the initial outlay cash flow.

An advantage of the finance methodology is its simplicity. A decision maker does not have to bother with the financing decision unless and until the investment project proves viable in terms of yielding a positive NPV. The operating officers are able to select projects without having to consider the firm's sources of financing. Once a project has been selected, the financial manager may then determine the source of funding that best meets the needs of the firm.

Two potential problems may emerge from separating investment decisions from financing arrangements. First, contemporary business choices are made using a team approach that employs accountants as well as financial managers in the decision-making process. Although theoretically it may be possible to separate investment, financing, and reporting aspects of a capital decision, the team management process requires communication among decision makers. In addition, in light of the dynamic nature of the investment banking field, the operating viability of a capital project may hinge on the currently available financing alternatives, a key feature that may be absent when separating investment from financing aspects of the capital budget.

Second, the separation of financing from operations assumes that a firm faces a perfect world where the capital structure of the firm is immaterial to the capital budgeting process. In other words, the evaluation of a capital project is independent of the amount of leverage the firm may acquire in accepting it. As a result, the finance approach leaves open the question of what discount rate is appropriate for any particular project. Finance texts are ambiguous on this point. Should the historical weighted average cost of capital be used or should a weighted average cost of capital that takes into account the newly proposed project's financing be utilized? If the firm currently has no debt, then its historical cost of capital is exactly equal to its cost of equity. If this same firm is evaluating a new project for which debt financing is available, should the firm use a discount rate based on 100% equity, or should it use a (perhaps lower after-tax) rate that incorporates some debt for the new project? Finance texts such as Principles of Corporate Finance, fourth edition, by Brealey and Myers, indicate that, "Borrowing does not affect the risk or the expected return on the firm's assets, but it does push up the risk of the common stock and lead the stockholders to demand a correspondingly higher return."(5)

But are not the stockholders the ultimate decision makers of a firm? If they require a higher return should not a higher discount rate be used as more debt is used in the firm's capital structure? Financial theory recognizes that the leverage of a firm will increase its riskiness, which at some point will raise the required rate of return on equity. If a firm embarks on a capital project with borrowed money, however, the leverage impact on the firm's required return on equity may not be felt for several years. Therefore, it may be more appropriate for the full cost of a capital project, in terms of its financing, to be embedded in the capital budget when it is first being considered.


The accounting perspective makes a distinction between income for reporting purposes and cash flows used for capital budgeting. Consequently, capital budgeting does not employ accrual methods and is concerned mainly with the cash inflows and outflows of a project as they occur.(6) Supporting this view is the statement of cash flows recommended by the Financial Accounting Standards Board (FASB). Among the purposes of a statement of cash flows are to predict future cash flows and to evaluate management decisions.(7) The statement shows where cash was acquired and how it was used. By relating the flows to their sources, a manager can determine what areas of the company are making a positive or negative contribution to the organizational goals.

Based on the fundamental purpose of the cash flow statement, the accounting discipline matches all flows according to their origin. The result is that interest expense is included in the operating activities section of the statement of cash flows.(8) For evaluation purposes, any interest expense resulting from monies borrowed is allocated to the project funded by such financing activities.

Table 2 illustrates how capital budgeting would conform to the accounting treatment. The project data for Table 2 is exactly the same as for Table 1. The firm's TABULAR DATA OMITTED capital structure is 40% debt and 60% equity. The component cost of equity is 13.6% and the federal plus state tax rate is 40%. Interest expense is included as an operating cash outflow, however. The discount rate used is a market-required rate of return of 16%. Under these circumstances the NPV is -$4,598 and the IRR is 8.9%. The market discount rate would have to decline to 6.4875% for the NPV to reach $1,889 and be equivalent to the value derived via the real estate approach.

Even though interest expense is included in the operating section of the cash flow statement, accounting texts are silent with respect to the incorporation of interest expense in capital budgeting cash flows. Horngren and Harrison,(9) Horngren and Foster,(10) and Moscove and Wright(11) do not deal with inclusion or exclusion of interest expense in capital budgeting. Because the FASB has only relatively recently accorded significance to cash flow accounting, it is not surprising that the interest expense issue has not yet been incorporated into accounting texts. However, managerial accounting issues related to cash flow statements and the financial risks associated with levering firms appear to highlight the need to address interest expense in capital budgeting decisions.

Another difference between the accounting and finance perspectives is in the use of discount rates to evaluate cash flows. The finance discipline prescribes the use of a weighted average cost of capital for the entity as a whole to discount the cash flows for each separate project. The accounting discipline advocates using a rate unique for a project or a class of projects TABULAR DATA OMITTED rather than the firm's weighted average cost of capital.(12) In addition, accounting texts recognize the special financing features individual projects may have and suggest only subjective methods for incorporating these factors into the discount rate. For example, Moscove and Wright state that:

Application of the present value method requires the selection of an earnings, or cutoff, rate to be used in calculating the present value of the anticipated cash inflows. No general agreement has been reached among accountants on how this rate should be arrived at, and no simple rules can be laid down. The cutoff rate selected tends to be based on subjective judgment rather than on any mathematical formula.(13)

The accounting approach to interest expense found in the statement of cash flows offers two advantages. First interest charges are explicitly included in the evaluation of the firm. The accounting treatment is consistent with the notion that interest expense is a relevant cash outflow to the firm from a going-concern standpoint. If the firm levers itself with debt, it risks insolvency and therefore the financing cost of the project should be directly recognized from a managerial accounting perspective. Second, the recognition of interest expense within a cash flow statement may overcome the problem of estimating the impact a proposed project's financing will have on the firm's future cost of capital. The initial inclusion of interest expense in the capital budgeting cash flow analysis eliminates the need to decide how financing will affect the cost of capital, because the expense is already recognized. By including interest expense as a direct cost to the capital project, a firm may be free to select a discount rate that will maintain the present capital structure.

The disadvantage of the current accounting approach is that texts have not dealt with the issue of interest expense in capital budgeting. The discussion of cash flow statements appears to support the view that interest expense is a cash outflow that should be included in capital budgeting decisions. Accounting texts have not as yet, however, addressed the issue by indicating whether interest expense should or should not be explicitly incorporated into capital budgeting cash flows. One apparent reason for this indecisiveness may lie in the way cash flow information is used within the accounting profession. Current interest in cash flow accounting is to show the historical position of the firm. Cash flow statements are used to demonstrate where the company has been in terms of the generation of income and expenditures from operations. Cash flows within this limited context are not being used to project the future advantages of accepting a particular project.


The equivalent procedure in real estate to capital budgeting is called the DCF model. The definition of the model as given by Wurtzebach and Miles is:

To bring together, in an analysis, all the factors that affect the return from a real estate investment. All cash flows are reduced to a single figure, the present value. These cash flows include all cash inflows, such as rents and proceeds of sale, and all cash outflows, such as operating expenses, taxes, and debt service.(14)

It should be noted that not only interest expense but also principal payments on the funds borrowed to acquire the property are included. In addition, the initial outlay for an investment does not include the entire purchase price but only the amount of the actual equity invested. That is, the initial outlay is the difference between the purchase price and the amount of the mortgage(s) obtained.(15)

The discount rate used in the real estate view is the after-tax return required on the equity investment.(16) That is, the rate used to discount the cash flows is derived from a project only and has nothing to do with a weighted average cost of capital, as in the finance view.

The basis for the real estate view is the integral role financing plays in real estate investments. Virtually no real estate investment takes place in which debt is not used. The procedure used to evaluate investment decisions explicitly takes this into account by relating the discount rate to the project and not to the cost of capital.

Table 3 provides an example of the real estate approach to capital budgeting using the same information contained in Tables 1 and 2. The initial cash flow represents only those funds invested by the firm in the project. Since the firm puts 20% down, its initial cash flow consists of 20% of $12,000 for the building, plus 20% of $8,000 for equipment. The firm is financed 40% through debt and 60% from equity and has a federal plus state tax rate of 40%. The analysis includes depreciation write-offs, principal and loan repayments on the financed portion of the project, and the interest on the amount of project financing each year. The firm's NPV is $1,889 and the IRR is 23.75%.

The advantage of the real estate view is that regardless of the conditions in the capital markets, the capital budgeting process uses timely inputs. Historical cost of capital may have little effect on future decisions because these costs do reflect what interest rates may do over the life of the project. Whatever interest rates are in the marketplace are the rates used to determine the attractiveness of each individual project. The real estate view recognizes the impact that leverage has on project returns by focusing on the portion of the project being financed and the amount that the firm invests. Because principal and loan repayments, depreciation, and interest expense are integral factors of importance to a real estate decision, it is only appropriate that these items appear in the cash flow statement.


It is apparent that the three disciplines of finance, accounting, and real estate have different perspectives on the process of capital budgeting. All three have similar definitions and purposes for using capital budgeting, but the inputs are inconsistent. The finance view ignores interest expense and the mode of financing of any particular project. That is, whether a project is funded by all equity or all debt has no impact on the analysis. The net cash flows are not changed to reflect financing nor is the discount rate adjusted. The initial outlay is included as the total cost of a project regardless of whether some or all of the cost was borrowed.

The accounting view holds interest expense to be a part of operating activities but does not include them in the cash flows for capital budgeting purposes. The accounting discipline does not provide any objective guidance in determining the appropriate discount rate, but there does appear to be agreement that the rate should be tied to a project and not to an entity's cost of capital. The accounting view includes the total cost of the project as an initial outlay the same way as in finance.

The real estate perspective is more explicit as to how interest expense should be treated. Real estate decision making includes interest expense in the cash flows for any given project. Further, the real estate view maintains that principal payments should also be included. Real estate differs from both finance and accounting in that only the equity invested in a project is included when calculating the initial outlay.

These inconsistencies can easily cause confusion in students trying to learn the process of capital budgeting. Further, the inconsistencies may result in different accept or reject decisions depending on which perspective is used. A consensus on one method should be reached to present a clear and unambiguous procedure for evaluating investments to students and practitioners. Presumably the method chosen would represent the one with the most positive attributes, which means decision quality would be maximized. Further, one consistent method would make analyzing the financial condition of enterprises more reliable.

1. Eugene F. Brigham, Fundamentals of Financial Management, 6th ed. (Chicago: The Dryden Press, 1992), 338. A comparable definition can be found in Austin J. Jaffe and C. F. Sirmans, Fundamentals of Real Estate Investment, 2d ed. (New Jersey: Prentice-Hall, 1989), 33-34; see also Charles T. Horngren and Gary Foster, Cost Accounting: A Managerial Emphasis, 7th ed. (New Jersey: Prentice-Hall, 1991), 673-674.

2. J. Martin, J. Petty, A. Keown, and D. Scott, Basic Financial Management, 5th ed. (New Jersey: Prentice-Hall, 1991), 152. See also Jaffe and Sirmans, 34; and Horngren and Foster, 705-714.

3. Richard Brealey and Stewart Myers, Principle's of Corporate Finance, 4th ed. (New York: McGraw-Hill, 1991), 103.

4. Brigham, 379.

5. Brealey and Myers, 190.

6. Horngren and Foster, 675.

7. Charles Horngren and W. Harrison, Accounting (New Jersey: Prentice-Hall, 1989), 701.

8. Ibid.

9. Ibid., 1005-1006.

10. Horngren and Foster, 680-681.

11. Steven Moscove and A. Wright, Cost Accounting with Managerial Applications (Boston: Houghton Mifflin, 1990), 825.

12. Horngren and Foster, 720. See also Raj Aggrawal and Charles Gibson, "Discounting in Financial Accounting and Reporting: Issues in the Literature," Financial Executives Research Foundation (1989): 4.

13. Moscove and Wright, 821.

14. Charles Wurtzebach and Michael Miles, Modern Real Estate, 4th ed. (New York: Wiley and Sons, 1991), 576.

15. Ibid., 588-589.

16. Ibid., 581.

Ason, Okoruwa, PhD, is an assistant professor of real estate and finance at the University of Northern Iowa. He received an MBA in finance from Georgia State University and a PhD in real estate from the University of Georgia. In addition to teaching, Mr. Okoruwa has provided real estate consulting services.

Arthur T. Cox, PhD, is an assistant professor of finance at the University of Northern Iowa. He received an MA in finance as well as a PhD in insurance from the University of Iowa. He has worked in the real estate brokerage industry with an emphasis on insurance valuation issues.

A. Frank Thompson, PhD, is head of the Department of Finance at the University of Northern iowa. He received a PhD in economics and actuarial science from the University of Nebraska. In the 1980s Mr. Thompson served as an AACSB Fellow to the federal government helping to calculate contingent loss reserves on failed savings and loan assets.
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Author:Okoruwa, Ason; Cox, Arthur T.; Thompson, A. Frank
Publication:Appraisal Journal
Date:Apr 1, 1994
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