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  1. Hello Sir,
    In the example 2 b

    NPV of the project when 100% equity is used from (a) is 19.64

    In part b we have 70% equity – why are we using NPV 19.64 (equity 100%) in example b when calculating APV?

    Should not we first calculate NPV when 70% equity (70%*100M) =70M

    0 (70M) * 1 . = (70)
    1-5 40M * 2.991 = 119.64

    NPV= 49.64M

    Gain from Debt is 9 M

    APV=49.64M + 9M = 58.64M

    I do not understand why 100% 19.64 is used instead 70% 49.64 is used when calculating APV.

    Thanks for your help

    • According to MM, the only difference between using all equity to finance a project and using part equity and part debt, is that the debt interest gets tax relief. It was not for that tax relief, then the NPV would be exactly the same however we chose to finance it.

      Therefore with APV we always first calculate the NPV as though it was entirely financed by equity (so the whole 100M coming from equity). If there was no tax, then the fact that in fact some of the 100M was coming from debt would be irrelevant – the NPV would be the same however the finance was raised.

      Because there is tax, then the NPV will be higher by the present value of the tax saving on the interest – we add it on to the NPV as if all equity financed to get the APV.

      The lecture and the answer in the lecture notes, are correct 馃檪

  2. Sir,

    Apologies if this has already been asked.

    If the debt goes on for longer than the project; to follow your example debt is taken over 7 years, do you include the additional years tax savings as well or end when the project ends?

    I also assume if debt is already in place it’s not included, only new debt for the project? (As with fixed costs)

    Thanks,
    Karl

  3. Hello Sir,
    from my little understanding, we use APV instead of the normal WACC method if there is a significant change in financial risk..So why in this example we did not consider that as a starting point before applying APV ??

    • If there is no other information (as there Is not here) then we have no choice but to assume that the debt is risk free and therefore the interest is the same as the risk free rate.

      The question says that the risk free rate is 5% (I assume, obviously, that you have downloaded the lectures notes containing the questions 馃檪 )

    • The question will usually specify whether to use APV of not. Otherwise, APV is a better approach if there is a major change in the gearing.

      CAPM is still usually also relevant – we need to use CAPM in order to calculate the ungeared cost of equity used to get the base case NPV.

      • Thank you John, for your prompt response,
        i would like to ask another question that why is APV method of project appraisal is used or is appropriate ,in case of significant changes in gearing levels of the company ,,,,,,, rather than recalculating Adjusted WACC.

      • The two would actually come to the same result, but the problem with using the WACC is that the gain from the project would affect the value of the equity and therefore the WACC – it would mean using a lot of algebra 馃檪

  6. Hi Sir,
    Thanks very much for your insightful lecture.

    For part (b) and (c), could you kindly explain why we take 100% equity instead of 70% when other 30% are accounted for debt financing? I thought it should be 70% equity and 30% debt.

    I did not want to ask you existing question but I still do not quite understand the logic after reading existing comments

    Thanks in advance!

    • It is not that we are assuming 100% comes from equity finance.

      With APV, we always first calculate the NPV as though it was all equity financed. According to Modigliani and Miller, the only difference if any debt is used is because of the tax benefit on the debt interest. So we then add on the tax benefit of any debt used.

  9. First of all, thank you @John Moffat for all your videos and support it has truly helped me through my studies.
    I just want to make sure my understanding is correct, with WACC we calculated Ke and Kd, due to the tax savings of debt the WACC is reduced as gearing increases, therefore the NPV increases.
    The effect of the above is similar to APV in that although we do not use Kd to discount the C.F. to obtain the NPV, we do incorporate the tax shield element in the second step and the sum of NPV and financing effects gives the APV.
    The result of using WACC or APV (given we have all necessary information in the question) should therefore result in more or less the same answer as each other because the decrease in WACC comes from the tax savings adjusted in Kd and the tax savings is what we are adding when calculating APV.

    • Yes, except for two things. Using M&M to get a cost of equity for the project and then using this to get a WACC assumes that the debt is irredeemable, whereas with APV we can deal with redeemable debt. Secondly, when using the WACC the NPV will be the gain to shareholders which changes the gearing and hence the WACC and so we go round in circles a bit 馃檪
      Whenever there is a significant change in the gearing, APV is the better approach.

  10. Sorry to dip my little fly in your ointment, but if we are taking the saving of the tax on the debt into consideration, why are we not taking into account the interest charge?

    NPV of the project gain = $19.64
    Tax shield = $9
    Interest charge on debt = $?

  12. Hi Sir, i refer to you example 2 and the question from BPP text book as below:

    (A company is considering a project that would cost $100,000 to be financed 50% by equity (cost 21.6%) and 50% by debt (pre-tax cost 12%). The financing method would maintain the company’s WACC unchanged. The cash flows from the project would be $36,000 a year in perpetuity, before interest charges. Tax is at 30%.

    Appraise the project using APV method.)

    I have no idea how to apply your example 2b techique to solve this BPP question as in this question no risk free rate figure was given

    • You should ask questions like this in the Ask the Tutor Forum and not as a comment on a lecture.

      You can calculate the ungeared cost of equity using the first formula on the formula sheet (M&M Proposition 2).

      I do not have the BPP Study Text (only the Revision Kit) but surely they have an answer in the book?

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