C6: Capital structure

Question 1

Limitations of APV method

Answer 1

1. Restricted to the evaluation of investment projects- fin risk diff proportion to the firm’s existing capital structure
2. Not widely accepted investment appraisal method - perception is complicated
3. Several treatment for certain items in the APV computation
   * Tax sheild can be discounted at pre-tax Kd or the Rf

Question 2

Adjusted Present value

APV

Use of APV = when changing in capital structure affects existing WACC

Answer 2

1. Base case value - Value of the project as if the company is ungeared (only financed by equity) > CFs are discounted using ungeared Ke
2. PV of tax relief on interest > due to interest arising on additional debt > CFs are discounted using Kd or the Rf
3. Issue costs = deducted from the above figures

APV = Base case value + PV of tax relief - issue costs

If the APV +ve, the project can be undertaken

Question 3

Adjusted Present value

Step APV

Answer 3

1. Calcualte a base case value of aproject using Keu(cost of equity for an ungeared company). > Give the value of the project as if it were ungeared.
2. Establish the PV of the tax shiled arisng as a result of the debt capacity generated by the project.
   
   • discount rate for tax shiled is the pre-tax cost of debt.
3. Adjust for the costs of issuing the finance.