Question

When should the WACC and the APV be used? How do personal taxes affect the use of these two methods? Use examples when explaining your answer.

Please only include the examples and be detailed.

Answer 1

Solution

1. WACC is the short form of Weighted Average Cost of Capital and represents the proportionate average cost of capital on the Owners funds & the Loan Funds. All types of funds are considered like Common Stock, Preference Stock, Bonds, Debentures, Loans etc.,

2. APV is the short form of Adjusted Present Value and represents the Sum of the Net Present Value of Cash Flows using Unlevered or Ungeared cost of Equity (all Equity Financed Firm) and the Present Value of Tax Shield on Debt Financing (Tax shield on Debt Interest, Tax shield on cost of Debt Issue etc.,)

3. Instances when to use the WACC ;

(a). When the firm has both Equity (Owners fund) & Debt (Borrowed fund) the required rate of return by both the fund providers are different as each holder has a varying risk appetite.

(b). Return payments on Loan funds are entitled to Tax benefits for the Firm while Equity funds are not.

(c). The above reasons lead to the Firm having different cost of capital and hence WACC or the Proportionate discounting rates are be helpful to evaluate projects.

4. Instances when to use the APV;

(a). Under the Adjusted Present Value method we don't assume a fixed proportion of Debt to Equity in the Firm's capital structure. Under differing capital structure (Debt to Equity mix) we can identify the Present Value of the project.

(b). Besides the impact of Tax Shield on Debt Interest this formula also considers the benefits of Tax Shield on Debt Issue etc.,

(c). It helps us to identify if an increase in the Debt of the total Capital leads to an increase/decrease in the NPV of a project.

Example of a APV (Adjusted Present Value)

Example of a WACC (weighted Average Cost of Capital)