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Dear Mr. John,
As I understand, APV assesses project based on NPV of project as equity – finance; Adjustment for benefit of interest tax shield, subsidiary benefit etc.
However, APV does not take into account of change in financial risk as capital structure change, right? therefore, no change in discounting rate used for Cash flows.
Thanks Sir in advance 🙂
Adding on the benefit of the tax shield on the debt is accounting for the financial risk – the approach assumes that Modigliani and Millers’ theory of gearing holds true.
Tax shield of interest is presented for only financial benefit (tax saved), not financial risk. I think financial risk reflected in cost of fund, means discounting rate.
I agree that it follow MM’s theory that debt is prefer for its tax saving. However, MM is also ignore financial risk when suggest Debt is superior than equity funds.
Not at all.
Everything that MM did in relation to their theories of gearing revolved around the risk to shareholders of greater gearing (which is what financial risk is!), and the assumptions that they made regarding the way that shareholders react to the increased risk due to more gearing.
That is precisely why they came to the conclusion that the WACC (and market value) would be unaffected by the level of gearing if there were no tax (and why therefore discounting at the cost of equity if no gearing would give the gain whatever the level of gearing, if there was no tax). With tax the only difference is the tax shield.
yes, Mr. John, I made wrong conclusion that MM ignore financial risk. But let’s return to APV here. I see know concern of change in financial risk in APV calculation. APV only take into account of tax shield as benefit, and ignore change in financial risk. Discount rate is still ungearing.
Please let me have your opinion here.
Thanks Mr. John.It is the same answer as before!
M&M do not ignore financial risk – they simply proved that financial risk has no affect at all on the market value of a company (and therefore on the gain from a project) except insofar as debt gives a tax benefit.
We risk playing with words – we do not specifically do anything about the financial risk in an APV question, but it is not because M7M ignore it. It is because they proved that we don’t need to do anything (apart, obviously, from dealing with the tax benefit).
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