Question

In the context of recent research on the Weighted Average Cost of Capital (WACC),
the Adjusted Present Value (APV) and the Flow-to-Equity (FTE), which of these
methods would you use for the following companies (explain your choice).

a) A firm with uncertain growth rates for the next 10 years.
b) A start-up firm with no debt.
c) A start-up firm with debt.
d) A financially distressed firm that has excess levels of debt but significant
accumulated tax credits.

Answer 1

a) A firm with uncertain growth rates for the next 10 years.:

WACC

A firm’s Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage of total capital and they are added together Based on which present rate is calculated.

b) A start-up firm with no debt.:

Flow to Equity

As firm have no Debt the company will calculate related to the Equity flow.

c) A start-up firm with debt.:

Adjusted Present Value (APV)

As it is used for the valuation of projects and companies. It takes the net present value (NPV), plus the present value of debt financing costs, which include interest tax shields, costs of debt issuance, costs of financial distress, financial subsidies, etc.

So why do we use Adjusted Present Value instead of NPV in evaluating projects with debt financing? To answer this, we first need to understand how financing decisions (debt vs. equity) affect the value of a project.

d) A financially distressed firm that has excess levels of debt but significant
accumulated tax credits.:

Flow to Equity

Flow to equity (FCFE) is the amount of cash a business generates that is available to be potentially distributed to shareholders. It is calculated as Cash from Operations less Capital Expenditures.