Adjusted Present Value (APV)

Question 1

Explain APV

Answer 1

-> is a business valuation method whereby either the asset, product or company as a whole is to be evaluated

Question 2

Financing effects are

Answer 2

1. The tax subsidy to debt- the value of the tax subsidy is TCD (TC is corporate tax rate and D is the value of the debt)
2. The costs of financial distress- the possibility of financial distress and bankruptcy arises with debt financing
3. The costs of issuing new securities- investment banks are compensated for their time and effort (a cost that lowers the value of the project)
4. Subsidies to debt financing- the interest on debt issued by governments is not taxable to the investor

Question 3

When to use APV

Answer 3

1. Investment appraisal in determining the effects of financing
2. Overseas projects where the financing side effects tend to be more expensive and complicated
3. Lease versus buy decisions in comparing the two forms of debt
4. MBO (existing managers buy out) and MBI (external managers buy in) where the main forms of financing will be debt managers having to borrow (asset rich but cash poor)
5. Capital intensive industry assessment (high risk industries- hotel, construction, airline)

Question 4

APV ADV

Answer 4

1. Focuses on the project and initially evaluates it irrespective of how it is financed
2. Explicitly values the various financing side effects
3. Discounts each relevant cash flow at its own risk adjusted cost of capital

Question 5

WACC DIS

Answer 5

1. it is an average cost of capital therefore doesn’t reflect cost of financing to the specific product
2. assumes no change in either business or financial risk
3. Assumes that debt is not paid back by company
4. Provides an overall NPV but does not separate the project from the financing side effects (does not look at specifics of project you are attempting to assess)

Question 6

Explain WACC

Answer 6

-> assumes debt is rebalanced and bundles all financing side effects into the discount rate.