Question

11. 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.

Answer 1

While WACC is a discount rate that is used in capital budgeting or project evaluation techniques, APV is a kind of capital budgeting technique. The two terms are not interchangeable.

WACC is the weighted average cost of capital for the entire firm. WACC is used as a discount rate for a project if the project's risk is equal or similar to the existing operational and financial risk of the firm's projects, and debt-equity structure of the proposed project is the same as existing debt-equity structure of the firm, that is, when leverage is unchanged. So, WACC is used when existing capital structure is stable and unlikely to change.

Adjusted Present Value (APV) is used when the firm expects a change in capital structure. APV is the sum of base-case value of project as if the project were completely equity-financed, and the value of financing side effects like cost of tax shield, issue costs, subsidy costs or costs of bankruptcy or financial failures.

Taxes affect both the methods. For WACC, a component of it is post-tax cost of debt. The higher the tax rate, the higher the interest tax shield and the lower the WACC. Equivalently, APV includes the effect of interest tax shield to the base case value and therefore, the higher the tax rate, the higher the interest tax shield and the higher the APV.