Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?...

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT?

A) For a given D/S, the WACC in the compressed APV model is greater than the WACC under MM's original (with tax) assumptions.

B) The value of a growing tax shield is greater than the value of a constant tax shield.

C) The total value of the firm is independent of the amount of debt it uses.

D) The tax shields should be discounted at the unlevered cost of equity.

E) For a given D/S, the levered cost of equity in the compressed APV model is greater than the levered cost of equity under MM's original (with tax) assumptions.

Expert Solution

Adjusted present value (APV), defined as the net present value of a project if financed solely by equity plus the present value of financing benefits, is another method for evaluating investments. It is very similar to NPV. The difference is that is uses the cost of equity as the discount rate rather than WACC. And APV includes tax shields such as those provided by deductible interests. APV analysis is effective for highly leveraged transactions.

The formula for adjusted present value is:

NPV (of a venture financed solely with equity capital) + PV of financing

In APV model, The value of a growing tax shield is greater than the value of a constant tax shield and The total value of the firm is independent of the amount of debt it uses. The tax shields should be discounted at the unlevered cost of equity. For a given D/S, the levered cost of equity in the compressed APV model is greater than the levered cost of equity under MM's original (with tax) assumptions.

Answer is (A) For a given D/S, the WACC in the compressed APV model is greater than the WACC under MM's original (with tax) assumptions.

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