Okan Sep /Dec 19

When calculating the APV, the base case NPV is always calculated using the cost of capital as if all equity financed. The benefit of the tax shield and subsidy is then added in order to arrive at the APV. Have you watched my free lectures on APV?

Yes I did but my question is not covered. I know how APV is calculated; there is the tax shield and subsidiy but I mean the ACTUAL interest expense paid, since it is a cost of capital as if all equity financed, then the ACTUAL interest expense should also be included when calculating APV no? Not just tax shield and subisdy..

No. The interest expense is not relevant ever (except when calculating the benefit of the tax shield later). For the base case NPV we are treating it as though the company is all equity financed (so there is no interest). According to M&M the only affect of there being interest is the tax benefit on the interest, which is accounting for separately (and I do explain this in my free lectures).

My question is why is it not relevant in APV; I am looking for the rationale behind as I am not really into merely applying formulas without really understanding the logic behind... If there were to be significant interest expenses, it would definitely have an impact of this appearing in the calculation and not merely tax savings and subsidies..

According to M&M the only difference between the value of a geared company and an all equity company is the tax saving on the interest. So with APV we calculate the NPV as though all equity financed (so no debt interest, and discounting at the cost of equity), and then we add on the tax saving due to the interest. (If there was no tax, then the value of the company would be the same whether all equity or whether geared - this is from Paper FM, but in Paper AFM there is always going to be tax, hence what I have written above.) Again, I do explain this in my lectures :-)