Recent advances in our understanding of capital structure decisions have not yet made their mark upon our capital budgeting techniques and practices. This paper attempts to bridge this gap. In doing this, it offers a surprisingly simple approach for managers to follow in marking financial decisions. The theory of corporate finance notes two alternative specifications of the weighted average cost of capital for discounting. In one, the cost of debt is specified in pre-tax terms while the tax shield on debt is accounted for in the cast flows. In another, the cost of debt is specified in after tax terms while the tax shield on interest is ignored in the cash flows. Theoretically the two alternative specifications of WACC and cash flows are considered equivalent. In practical terms, however, what concerns a manager is which of the two specifications he should employ in financial analysis. In this paper, we take the view that the first specification above is superior to the second one on several counts: for one, it is conceptually closer to our intuitive understanding of cost. Further, it facilitates taking explicit account of a number of important considerations such as certain costs which alone can explain capital structures not tending towards 100% debt. It also allows us to explicitly consider tax shields on interest only in time periods in which they can actually be absorbed; it permits us to handle bonds, common in India, where the coupon rate of interest is different from the yield to maturity; and to incorporate the loss in value from equity issues made below market price. This insight leads us to a resolution of the perennially vexing issue of how to value debt and leases. We go on to propose a simple two-step procedure for making financial decisions. This leads us, in conclusion, to call for a new and more meaningful distinction to replace the conventional distinction between investment decisions and financing decisions.
