Project Evaluation Model - interest expense

[lioudmilarangel@yahoo.com]

I’m trying to create a financial model for a local real estate company and was wondering what to do with mortgage expense calculating the project cash flow.


I know that interest part of the mortgage should be deducted before calculating taxes and Net Profit.

Then, one of my financial management books says that “interest expenses are not included in project cash flows” because “the discounting process reduces the cash flows to account for the project’s capital costs. If interest charges were first deducted and then the resulting cash flow were discounted, this would double count the cost of debt.


Thank you.

 

[kchiba]

Hi,


Do not confuse cash flow with Profit. Cash Flows also take in the movement in working capital. As to the question of interest, the theory is that you are comparing the return on your investment against what you can earn on the investment if the money was placed elsewhere and that the rate of interest is a financial decision and not an operating one.

The amount of interest also varies depending on the gearing that you have, that is your own money vs the borrowed money. So project may cost 100 and 5% interest is 5 if you use only borrowed money, but it can be 2.5 if you borrow only 50 and use 50 of your own money. These are financial decisions and may not have anything to do with what the project can return.

Thus you have to be very careful when factoring interest into the cash flow. You will also have a problem in what you use as the discounting rate, if you factor in the interest. Noramlly the discounting rate is based on a rate for a safe investment (treasury bills) plus the risk premium, so the interest is implicit in the rate of the safe investment