On the separability of the real and the financial decisions in project analysis

The financial manager faces two basic problems: First, the firm’s investment, or capital budgeting, decision; Second, the financing decision. Capital investment and financing decisions are typically separated, that is, analyzed independently. The basic idea behind Modigliani and Miller’s famous proposition I is that: In perfect markets changes in capital structure do not affect value. As long as the total cash flow generated by the firm’s assets is unchanged by capital structure, value is independent of capital structure. The aim of this paper is not to attack or discuss MM theorem. The theorem is mentioned because capital budgeting applies the same rule to projects, and projects as opposed to firms are not supposed to last forever or indeterminately. If we introduce a time limit to investments, to separate investment and financing decision in project analysis markets might not be correct, even in a perfect market. The purpose of this paper is to explore the validity of the separation rule trough NPV and IRR rules, as representatives of academic and business practice, and compare their results with simulations that will include the financial decision of the firm. The analysis will take into consideration what would happen when the flow of funds from investments differs from the flow of funds that finance the project, not the financial structure or distribution among bonds and stock. A singular experiment proving that we can change the net present value of an investment modifying the financial structure, cannot be used to affirm a universal statement; however, it can be used to show that a theory is wrong.