Question

There are three approaches in the Income Method (WACC, APV and Equity methods). For each prompt below, which approach would you recommend?

a.The Company has a target capital structure of 60% debt and 40% equity and it expects to make capital adjustments to stay at that level going forward.

b. The Company just took out $5M in debt and plans on paying it off installments over the next five years. There are no plans to acquire additional debt in the future.

c. In your valuation, you want to use cash flows that would be after paying interest on the debt.

d. You want to value the interest tax shield separately.

Answer 1

a). WACC approach is recommended here.

Weighted average cost of capital is the rate at wich company pays to the security holders. When company raise money from issue of Common stock, preference shares, debt, debentures , WACC takes in to account the weights of each component of capital structure.

Companies may take WACC approach when investment projects available with them is worthwhile to undertake. When company raise funds more than one source i.e debt & equity in such case a WACC is appropriate which indictes minimum rate at which company should earn from business to prvide returns to it financers.

b). WACC approach

APV method is often used when companies capital structure is expectedly change over the investment horizon

Here company took debt wants to pay in installment and no plan to obtain additional loan in future. WACC discount rate is expectedly used when capital structure relatively stable.

c) WACC approach

Interest payment is tax deductible means interest allowed before tax. WACC is used to discount cash flows after paying of interest on debt.

As per APV method value of firm calculated by taking equity finance and PV of tax shield of debt

equity method used when firem is all equity financed.

d) APV approach

WACC is the discounting rate, values the interest tax shield associated with use of debt without having value it separately.