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Adjusted Present Value (APV)

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Adjusted Present Value (APV)

1 Adjusted Present Value (APV) 1.1 Calculation 1.1.1 Basic principle 1.1.2 The investment element (Base case NPV) 1.1.3 The financing impact 1.2 Further complications 1.2.1 Subsidised/cheap loans 1.2.2 Debt capacity 1.3 Advantages and disadvantages of APV

Adjusted Present Value (APV)

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Adjusted Present Value (APV) is an approach to investment appraisal that should be used if the if the financial risk of the company is expected to change significantly as a result of undertaking a project. A discussion of different approaches to investment appraisal can be found here. This approach separates the investment element of the decision from the financing element and appraises them independently. APV is also recommended when there are complex funding arrangements (e.g. subsidised loans).

Calculation Basic principle The APV method evaluates the project and the impact of financing separately. Hence, it can be used if a new project has a different financial risk (debt-equity ratio) from the company, i.e. the overall capital structure of the company changes. APV consists of two different elements:

The investment element (Base case NPV) The project is evaluated as though it were being undertaken by an all equity company with all financing side effects ignored. The financial risk is quantified later in the second part of the APV analysis. Therefore: ignore the financial risk in the investment decision process use a beta that reflects just the business risk, i.e. βasset.

The financing impact https://kfknowledgebank.kaplan.co.uk/adjusted-present-value-(apv)-

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Adjusted Present Value (APV) Financing cash flows consist of: issue costs tax reliefs.

As all financing cash flows are low risk they are discounted at either: the Kd or the risk free rate. Issue costs A firm will know how much finance is required for the investment. Issue costs of finance will usually be quoted on top. It will therefore be necessary to gross up the funds to be raised. Issue costs for debt will be eligible for tax relief so this must be incorporated. Tax reliefs As well as tax relief on debt issue costs, the main financing side effect is to calculate the present value of tax relief on debt interest payments, also known as the tax "shield". This gives the following overall calculation:

Further complications Subsidised/cheap loans If a loan is cheap, the interest cost is lower. However, the benefit is reduced since the tax shield will also be lower: PV of the cheap loan (opportunity benefit):

Debt capacity Debt finance benefits a project because of the associated tax shield. If a project brings about an increase in the borrowing capacity of the firm, it will increase the potential tax shield available. An occasional exam trick is to give both the amount of debt actually raised and the increase in debt capacity brought about by the project. It is this theoretical debt capacity on which the tax shield should be based. A project's debt capacity denotes its ability to act as security for a loan. It is the tax relief available on such a loan, which gives debt capacity its value. When calculating the present value of the tax shield (tax relief on interest) it should be based on the project's theoretical debt capacity and not on the actual amount of the debt used. The tax benefit from a project accrues from each pound of debt finance that it can support, even if the debt is used on some other project. We therefore use the theoretical debt capacity to match the tax benefit to the specific project. For example, if a question stated that actual debt raised is $800,000 but you are told in the question "The investment is believed to add $1 million to the company's debt capacity." The present value of the tax shield is based on the £1 million - the theoretical amount.

Advantages and disadvantages of APV The APV technique has practical advantages and theoretical disadvantages.

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This Product includes content from the International Auditing and Assurance Standards Board (IAASB) and the International Ethics Standards Board for Accountants (IESBA), published by the International Federation of Accountants (IFAC) in December 2012 and is used with permission of IFAC.

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Kaplan Financial Limited. Copyright 2012.

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