A financial analyst included the interest cost of the debt used to buy new machinery in the cash flows from a capital budgeting project. Is this correct or incorrect? Why?
This is incorrect. The proposed project will be evaluated against a cost of capital after its estimated cash flows are summarized. To include interest in the project’s cash flows risks double counting the cost of this capital. In addition, it is not clear which debt will be used to fund the project if it is accepted. Finance theory argues that it is better to wait and incorporate the cost of capital into the analysis after the project’s projected non financing cash flows and risks are summarized.