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Hi sir,
I had some confusion regarding evaluating a project through Apv & Npv. Just wanted to confirm my understanding, when we discount the project using WACC, we get the Npv which represents the value of the project for the whole company, i.e. (debt+equity).
Whereas, when we discount the operational cash flows of a project using ungeared ke, and then add the present value of tax benefits on interest (which effectively increases the value of the project for shareholders), we get Apv, which represents the value of the project for the equity holders of the company.This implies that evaluating through Npv, gives the value for the whole company, whereas evaluating through Apv, gives the value for the equity holders of the company. Am I right sir?
There is an example in bpp, where they have evaluated a project, which does not affect the capital structure, using Apv, and the answer represents the total value of the project for the company (same as Npv), but when the same project is evaluted through Apv, with the only difference that it changes the gearing structure of the company, the answer says that the project would increase the value of equity by the amount of Apv.
Why is it, that when the project is first evaluated through Apv, it represents the value of the project for the whole company, but when exactly same project is evaluated through Apv, with the only change in gearing level, the answer represents the value of the project for equity investors only?
What does Apv actually tells us, the value for the whole company, or for equiy investors only?I think that you are confusing two things – appraising a project, and valuing a company.
If we are appraising a project, then both NPV (discounting the project flows at the WACC) and APV (discounting the project flows at the ungeared cost of equity and then adding on the tax benefit of the debt used to finance the project) both give the gain from the project, and in both cases the gain goes to the shareholders. APV is the better approach when there is a substantial change in the gearing.
When we are valuing the company as a whole, then either we discount the cash flows before interest at the WACC – this gives the value of the company as a whole (equity plus debt), or alternatively we discount the cash flows after interest at the cost of equity, and this gives the value of the equity.
In the second case that you mentioned, will we discount cash flows after interest using geared or ungeared cost of equity, to get the value of equity?
Because in some questions, even when the company is geared, its value is calculated by discounting at the ungeared cost of equity.In the second case we discount at the actual (geared) cost of equity.
You say that in some questions the value is calculated by discounting at the ungeared cost of equity. Unless is an APV question (where, of course, we always discount at the ungeared cost of equity as already explained) then it would only be because of something specific in the question.
You would have to give the name of a specific question for me to be able to explain.
Yes, I got it, those are APV questions. Can you please tell me in which situations we value a target company using APV method rather than NPV? Is it only when the acquisition is being financed by debt (acquirer raises new debt finance) or there are other reasons as well, because in a book example, a target company is valued using APV method, but there is no mention of the acquisition being financed by debt. The tax savings are calculated on the existing debt of the target company.
I thought APV is only used, when new debt finance is raised & hence capital structure changes, but in the example, tax savings are calculated on the existing debt of target company, how can an existing debt change the capital structure of the company?I have another question, in case of free cash flows for equity, it is mentioned in book that interest payments redemption values of debt are deducted & then the cash flows are discounted using cost of equity. What is meant by the redemption value here, it is the nominal value at which the debt will be redeemed not the market value, am I right?
We use APV when appraising a project if there is a substantial change in gearing.
It is unusual (certainly in the exam) to value a company using the APV approach (normally we either discount the before interest flows at the WACC to get the value of the whole company, or alternatively discount the after interest flows at the cost of equity in order to value the equity). You would only use an APV approach here if the question specifically asked you to.
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