- We have looked at NPV calculation and we use WACC(weighted average cost of capital) to discount cash flow.
- WACC has incorporated debt and equity element and one of the arguments for this is future sales, costs incurred have nothing to do with financing but instead they are something to do with operations.
- So that’s why we developed APV to separate business option from financing.
- APV is used when you are appraising a project where its financial risk is changed.
- This means we use cost of equity(ungeared) to discount the basic cash flow including revenue & expenses because they are something to do with business not finance.
We can then establish present value of finance effect including issue cost, tax saving on interest and subsidy as well and for these items we use risk free rate/cost of debt to discount because APV doesn’t specify which discount rate we should choose and you can argue that eg, for tax saving on interest we have no idea when tax rate may change and as a result we can use Rf or Kd to discount the cash flow. Here notice you can either use Rf or Kd to discount cash flow and whichever you use your examiner would give you a mark in the exam(although your answer may be different from examiner’s and that’s totally acceptable).
APV=Base case NPV + PV of Finance Effect