So far, we have treated investment and financing to be separate and have not considered any interaction between the two. This assumed the MM perfect market world where the investment decisions could be made without any reference to how the investments are financed. This chapter provides you with tools required to make investment decisions when they are affected by financing decisions. The chapter gives useful and practical pointers to deal with capital budgeting situations where investment and financing decisions interact. The chapter also explains how to handle the cash flows which are very safe or of low risk.

The chapter describes two equivalent approaches to incorporating the effects of financing interactions. The first approach uses the popular and widely used tool of the weighted-average cost of capital (WACC). WACC incorporates the effect of tax shields into the discount rate used to value the cash flows produced by a project. WACC is typically calculated using actual market data and balance sheets for companies or industries. Usually, WACC works quite well, if you know its limitations and potential pitfalls.

The second approach adds the present value of the financing effects to the base-case net present value and calculates the adjusted present value or APV of the project. The modified MM proposition I described in Chapter 18 is an example of the APV approach. The approach is very general and can be useful in cases where WACC does not work very well because the assumptions for the correct use of WACC are violated. The APV approach is also useful in cases where the project or the investment decision involves special or subsidized financing or costs of issuing securities needed to finance the project.

Before we begin the lessons of this chapter, it might be useful to have a quick review of the investment decision making process we have used so far. The following steps are involved in evaluating investment opportunities:

• Forecast the project's incremental after-tax cash flows.
• Assess the project's risk.
• Estimate the opportunity cost of capital.
• Calculate NPV, using the discounted-cash-flow formula.

Remember that the opportunity cost of capital reflects the projects business risk and does not include any effect of financial leverage. This chapter tells you how to incorporate the effect of borrowing.