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When Adjusted Present Value (APV) approach is used?
The Adjusted Present Value of a project takes the Net Present Value (NPV) of a project and adds this with the cost of debt, including financing effects, such as interest tax shield, issue costs, costs of distress, and subsidies etc. The APV is used instead of NPV for evaluating an investment project for various reasons. Here's why APV is used more frequently than other methods of evaluation of a project.
The Effect of Debt and Equity
The use of all-equity financing may be debilitating for the health of a company's financials. In some situations, the NPV of such project turn positive due to capital cost decreasing with leverage. Therefore, a project with 100 percent equity financing may be rejected, while the one with some debt in it may be opted.
The APV approach considers the effect of raising debt which the NPV does not. Therefore, APV offers a clearer picture of the overall outcome of debt financing.
The APV approach considers the project valuation when the debt is fixed rather than when the debt ratio is constant. Hence, the APV approach offers more flexibility to consider the changing equity levels in order to offer a better idea about the financial health of a project.
Why APV Approach is Used?
The Adjusted Present Value approach is used in the following scenarios −
When Different Projects Have Similar Risk Profiles
The APV approach is used when the risk of a project or the average risk of a project is equal to the other projects in consideration. The required discount rate for the project in such cases is based on the risk of the firm.
Therefore, when the risks of projects do not differ, the APV approach is the better one to evaluate the worth of an investment.
When the Focus is on Interest Tax Shield
When the focus of an investment project rests on the interest tax shield on a corporate level, the APV approach is highly recommended for use. In such cases, the amount of tax is palpable and due to this substantiality, the use of APV approach is satisfactory to find the cost of interest tax shield of the project. In fact, the consideration of APV approach is satisfactory in the case of financing where both debt and equity are included. However, to offer a bigger picture, the debt part of the financing must be constant and the debt-to-equity ratio should only change of the project under evaluation.
When the Debt is Perpetual
The APV approach is also effective when the debt is considered perpetual. That is, when the debt of project remains same for infinity, the easiest method to find the value of a project is via the APV mode. However, it must be noted that both the APV and CCF methods are applicable to the similar circumstances to derive the value of a project. So, the choice of a project is more for simplicity rather than for theory.
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