WACC APV - Wacc/apv notes PDF

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Wacc/apv notes...

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WACC and APV: - WACC and APV use different discount rate. APV uses the fixed debt policy, discounted at the cost of debt. If the level of debt is fixed, the tax shield may have the same risk as the debt. WACC approach uses the constant leverage policy, discounted at the expected asset return. If the level of debt varies with firm value, the tax shields are a fraction of the firm’s value, and so they inherit its risk. - WACC approach can be used to value project financed with all equity, or financed with constant leverage. APV approach can be used to value the project financed with a fixed level of debt, or project with predetermined debt repayments. - WACC and APV are differentiated in formation.

APV: Ad: Extremely useful in situations where capital structure is expected to change over time and the project is financed heavily with debt (e.g. LBO analysis, leveraged recapitalisations). Also useful for projects with numerous financing side effects (e.g., international projects with subsidies or restrictions). It can also be used to value other market imperfections. As Luehrman states that APV method is transparent and informative. It shows how much value is there and how it is created, thus allows managers to measure their contribution to value.

Dis: Problems when valuing projects with a constant leverage ratio. To determine the interest tax shields, one needs to know the debt level, which can only be calculated from the project’s value. It is easier to use the WACC method when the leverage ratio is constant. The value of debt interest tax shields is likely to be overestimated. Not always easy to value other financing related costs and benefits. It is inconsistent with the functional separation between operating and financing decisions. In theory, the WACC and AVP methods should provide consistent results (provided that there are no financing side effects other than corporate taxes) (See Inselbag and Kaufold, 1998).

WACC Assumption: Based on the firm’s current characteristics, but is used to discount future cash flows. Only applicable to new investments that are of comparable risk to the rest of the firm, and will not alter the firm’s capital structure, i.e., constant market leverage ratio. It is not suitable for leverage recapitalisations, LBO.. it assumes taxes as the only market imperfection. What about other imperfections such as issuance, financial distress and/or agency costs.

In reality, Most theories of capital structure argue that leverage changes as firm value changes. The level of debt is likely to grow as the activities of the firm and its value grows. However, firms tend to issue equity securities when their values are high (market timing hypothesis). The trade-off theory of capital structure suggests that firms have target leverage. Surveys show that 80% of firms have target leverage (Graham and Harvey, 2001) Target leverage as a function of firm specific factors. Leverage may fluctuate within a target range due to costly leverage adjustment (e.g. Leary and Roberts, 2005). Firms adjust towards target leverage in the long-run. Overall, it is more appropriate to assume that debt varies with value....