Dear Mr. Miller!

I had an analogous question as Deyan to whom you had answered here

I've read your explanation and clarified my understanding that NPV should be based only on operational cash inflows/outflows not financial ones because they are irrelevant. However, I have some additional questions.

1. What shall we do if proposed project changes our capital structure and we should borrow some money to finance that project? I think in this case financial cash flows became relevent. If the goal is to increase wealth of shareholders, we should take cash flows from financing activity because shareholders will receive only part of cash flows from operating activity after debt repayment.

2. About comparing several projects based on NPV method. I've read that one should choose mutually exclusive projects with different initial outflows based on PI index = PV/Initial outflows: the higher PI the more viable project. However, I think that projects should be comparable and thus the answer depends on capital suplly.

For example, a company  ABC has $100 and chooses between 3 projects with initial outflows $80, $100 and $120, respectively.
I suppose that those projects are not comparable because ABC does not have enough money to launch the third projects without external financing. Likewise, if ABC chooses the first project, it will have unused $20 and we should take into consideration potential proceeds from investing that amount.

Thus, I propose to modify the projects:
the first project -> the first project as before + deposit ($20)
the second project -> the second project as before
the third project -> the third project as before + loan ($20)

and than appraise those projects taking inro account additional cash flow from deposit for the fisrt project and financing cash flow for the third project. In that way we consider both alternative (and thus relevant) gain and relevant finance costs.

Could you please clarify that moments?

Thank in advance!

Best regards, Vasiliy

Vasiliy - You write English very well. I guess the problem is either that I write poorly, or you read poorly. Let me say this one last time: HOW THE PROJECT IS FINANCED HAS ZERO IMPACT ON ITS NPV. THE PURPOSE OF NPV IS TO ASSESS THE ECONOMICS OF THE PROJECT, NOT THE FINANCING OF THE PROJECT OR THE ACCOUNTING FOR THE PROJECT.


The fact that taking on some debt to help finance a project changes a company's capital structure is, again, irrelevant to what we're doing here. Once again, you're confusing accounting with economics. The discount rate for capital budgeting is the rate appropriate to the riskiness of the expected debt-free [i.e., no interest] cash flows from that project. How the project will be financed is a separate and unrelated issue.

Let me put this another way: We cannot hold managers responsible for project outcomes if they have no say in the financing. That is why we tax-effect Operating Income (EBIT) for a project, not Pretax Income. Financing considerations must be omitted from the capital-budgeting analysis. Besides, few operating managers have authority over project financing anyway. Financing issues are typically dealt with by the Board or by senior managers who are NOT running the projects.

Let me say it a third way: Unless a company has an excessive amount of debt--how much constitutes "excessive" is a function of facts and circumstances in a particular case--then its weighted-average cost of capital (WACC) will ALWAYS be lower than its equity discount rate. That is because debt costs less than equity. Therefore, if NPV is positive on a debt-free basis, you can be 100% sure that it's positive on a WACC basis.

Finally, let me say this: a well-run company would not undertake projects whose risk is lower than its equity discount rate because it would then be using a source of capital whose cost exceeded the returns generated by the investment. Even in those cases, though, the accounting would report a "profit," wouldn't it? Yet, the firm would be destroying value on an economic basis . This is why most accountants make lousy CFOs: we can take the professional out of accounting, but we cannot take accounting out of the professional. And I say that as a Certified Public Accountant myself who is also a former CFO.

I trust that you understand why I do not need to respond to your specific questions:

(1) It's not necessary if you can read what I wrote above, and

(2) I've dealt with this most basic issue until I'm blue in the face.

If you understand that economics and accounting are not the same --which you really do need to grasp ASAP if you do not yet--then you'll understand exactly what I'm saying here. If you do not, then I'm sorry, but I simply cannot say it any more clearly than I've already said it. Repeatedly: Don't confuse the economics of a project with its accounting.

Take care, and good luck.



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Warren D. Miller, CFA, CPA, ASA


My expertise in economics is limited to three sub-disciplines: Austrian economics, industrial organization, and evolutionary economics. Questions dealing with macroeconomics and other sub-disciplines of the subject should be submitted to those who have the appropriate expertise. N.B.: I DO NOT ANSWER QUESTIONS MARKED 'PRIVATE' because I believe that knowledge should not be hoarded. I also believe that such questions are likely to come those trying to cheat. Also, as one who was a full-time academic for half a decade, I can recognize test/homework questions several time zones away. Do not demean yourself by submitting such questions to me. Those who do so are cheating; I WILL call you out publicly. I have a zero-tolerance policy for cheating and dishonesty. In addition, please don't emulate the businessman who posted a request for help in August 2008. He expressly denied that he was seeking "investment advice" and said that his query was for, and I quote, "educational and informational purposes." Later, he allowed as how his questions related to the possible purchase of a $500K piece of equipment. I said I thought he had misrepresented himself. Bottom line: high-end business consulting is how I make my living. I am the sole support for my family. Please respect that fact and don't try to get for free what our clients pay for. If your company is big enough to have a sophisticated problem, it can afford to pay for the expert advice we and others provide. Beckmill Research, LLC, is a 95-octane firm. We're small, but we've been at this for nearly 20 years. We know what we're doing. Segue: Early on, some asked me for career advice; I gave it. I now get many such requests. The demand for a valuable good that is free is unlimited, so I now charge for that advice. Email me: Finally, PLEASE DO NOT ASK FOR INVESTMENT ADVICE. I am not licensed to provide such advice. If you want such counsel, talk to your financial planner or other financial adviser.


I work with Austrian economics (which differs in major respects from the traditional economics), industrial organization (which is about industry structure, conduct, and performance), and evolutionary economics (almost, but not quite, the economic analog of its biological counterpart) every day in my work. I appraise closely-held businesses, provide exit-planning services, and offer high-level strategic analysis, advice, and solutions to CEOs and owners of mid-sized businesses. Understanding, applying, and writing about these disciplines is an essential part of how I have made my living since 1993.

CFA Institute, Strategic Management Society, American Society of Appraisers, Academy of Management, Culver Legion, National Association of Scholars.

CFA Magazine, Strategic Finance, Valuation Strategies, Journal of Advanced Property Economics, Harvard Business Review, American Fly Fisher, CFA Digest, CPA Expert, Business Valuation Review, among others

Chartered Financial Analyst designation (2006); Accredited Senior Appraiser in Business Valuation (2006); Certified Public Accountant (1992); MBA - Oklahoma State University (1991); Completed all of my Ph.D. coursework in strategic management - Oklahoma State University (1983-87); BBA in finance and accounting - U. of Oklahoma (1975)

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Business Valuation Volunteer of the Year (2001) - American Institute of CPAs; Winner - Oklahoma Humorous-Speaking Contest - Toastmasters International (1971)

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