ACCA Strategic Professional · Advanced Financial Management
Impact of Financing on Investment Decisions and Adjusted Present Values
Adjusted present value (APV) values a project in two steps. First, discount operating cash flows at the ungeared cost of equity to get the base-case NPV. Then add the present value of financing side effects, such as the interest tax shield, and deduct issue costs. Accept the project if APV is positive.
What this chapter covers
This chapter shows how the way a project is financed changes its value. The basic NPV method uses one discount rate that blends the cost of debt and equity. That rate assumes the project has the same business risk and the same gearing as the company. Often neither is true. APV avoids the problem by separating the investment decision from the financing decision.
You value the project as if it were all-equity financed. Then you value each financing side effect on its own: the tax shield on interest, issue costs, and sometimes subsidised loans. You add these together. You also learn how to estimate an ungeared cost of equity, usually by ungearing a proxy company's beta, and how debt capacity decides how much tax relief you can claim.
The chapter links to the rest of AFM in several ways. It builds on basic NPV, the CAPM and the cost of capital from earlier studies. It feeds into the investment appraisal and cost of capital questions, and into topics such as international projects, mergers and acquisitions, and financing choices. APV often appears in a Section A case study or a 25-mark Section B question, so you must be able to calculate, explain and advise.
APV is a core AFM technique and it suits the exam's written, scenario-based style. The calculations are manageable once you have a fixed layout, but marks also come from explaining your assumptions, judging whether the numbers are reliable and advising the board. Technical marks reward correct steps, such as ungearing the beta, timing the tax shield and treating issue costs properly. Professional skills marks reward analysis, commercial judgement and clear communication of a recommendation. Students who learn only the arithmetic lose the discussion marks. Students who learn only the theory lose the calculation marks. Working on both in this chapter pays off, and the ideas also support other AFM areas where financing and risk change a valuation.
Impact of financing on investment decisions and adjusted present values: topics in the order to study them
- 1Adjusted Present Value (APV) MethodStart with the overall structure: base-case NPV plus financing side effects, so every later topic has a place to fit.
- 2Ungeared Cost of Equity and Business Risk AdjustmentYou need the base-case discount rate before you can calculate the first part of APV, and this is where beta ungearing and regearing are practised.
- 3Financing Side Effects: Tax Shield and Issue CostsWith the base case in hand, you add the second part of APV: the tax shield on debt interest and the cost of raising finance.
- 4Debt Capacity and Project Financing AssumptionsThis sets how much debt the project supports, which decides the size and the discount rate of the tax shield, so it comes after the tax shield basics.
- 5APV versus NPV: Choosing and Evaluating the MethodsStudy this last, once you can do both calculations, so you can compare them, choose between them and discuss limits in written answers.
How to prepare Impact of financing on investment decisions and adjusted present values
Treat this chapter as one fixed layout plus a set of judgement points. Practise the layout until it is automatic, then spend your time on assumptions and explanation.
- Write out the APV layout from memory: base-case NPV, then tax shield, then issue costs and other side effects, then total APV and decision.
- Practise ungearing and regearing betas with a proxy company until you can do it without checking the formula. Always state which tax rate and which debt beta assumption you use.
- Work the tax shield by hand. For each year, find interest, multiply by the tax rate, and discount at the rate you can justify, usually the pre-tax cost of debt. Check the timing of the tax saving.
- Do short past-style questions on debt capacity. Decide how debt is defined, such as a share of project value or of asset value, and see how it changes the shield.
- Write a one-paragraph comparison of APV and NPV for each question you practise. Cover when each is suitable, what each assumes and what could make the answer unreliable.
- Attempt full timed questions. Add a short recommendation to the board with a clear decision, the key assumptions and the main risks. Mark your own answer against both technical and professional skills points.
- In the last week, redo your weakest question and review your error list rather than starting new material.
Common mistakes in Impact of financing on investment decisions and adjusted present values
Using the company's own cost of equity for the base case when the project has a different business risk.
Fix: Find a proxy company, ungear its beta and use the resulting ungeared cost of equity as the base-case rate. Say why you chose it.
Mixing up geared and ungeared betas or applying the tax adjustment wrongly.
Fix: Write the formula each time, label each term, and check that debt and equity are measured in market values. State any assumption on debt beta.
Calculating the tax shield on the wrong interest amount or in the wrong years.
Fix: Build a small table by year showing debt balance, interest, tax saving and discount factor. Follow the timing in the question.
Forgetting or mistreating issue costs.
Fix: Put issue costs in your layout as a standing line. Base them on the funds raised, and check whether the question says tax relief applies.
Giving only numbers and a bare accept or reject.
Fix: Add a short paragraph on assumptions, reliability and risks, and give a clear recommendation. This earns discussion and professional skills marks.
Treating APV as always better than NPV, or the reverse.
Fix: Compare the methods against the facts given: financing pattern, gearing changes, side effects and data available. Then pick one and justify it.
Last-day revision: Impact of financing on investment decisions and adjusted present values
- APV = base-case NPV + PV of financing side effects.
- The base-case NPV discounts operating cash flows at the ungeared cost of equity.
- Ungear the proxy beta before using it, then use the ungeared cost of equity in the base case.
- Business risk of the project, not the parent company, decides the base-case rate.
- The interest tax shield = interest × tax rate, counted only when the interest is tax deductible and there are profits to use it.
- The tax shield is usually discounted at the pre-tax cost of debt, since its risk is linked to the debt. State your assumption.
- Issue costs are a cash outflow at the start. Deduct them and note whether they are tax deductible.
- Debt capacity sets the amount of debt that supports the project and so the size of the tax shield.
- A positive APV means the project adds value. Accept it.
- APV is suited to projects with a changing financing mix or special finance. NPV with a single rate suits stable gearing.
- Always list your assumptions in the answer and say what happens if they fail.
- End with a clear recommendation and the main risks.
Impact of financing on investment decisions and adjusted present values practice questions
- Delta Ltd has a project with a base case NPV of $1,200,000. It will raise $6 million net of costs by a debt issue; issue costs are 2% of the…
- Nyala Ltd is an all-equity project-financed company with an equity beta of 1.20. Risk-free rate is 4% and market return is 9%. Under the APV…
- A company uses APV to appraise a project financed by newly issued debt. Which of the following is a financing side effect that should be inc…
- A company with a constant debt-to-equity ratio of 1:2 (by market value) has a geared cost of equity of 12%. Its pre-tax cost of debt is 5% a…
- In the adjusted present value (APV) method, at which rate are the base-case after-tax operating cash flows of a project normally discounted?
- Bexley Co is appraising a project costing $10m now. It will give after-tax operating cash flows of $3.2m a year for 5 years. The ungeared co…
- Orla plc is appraising a project costing $4m. The base-case NPV, discounted at the ungeared cost of equity of 8%, is $300,000. The project i…
- Zeta Co will borrow $4 million of debt at 6% annual interest for a project, with interest paid at each year end for 4 years and the principa…
Impact of financing on investment decisions and adjusted present values in other exams
The same ground in other exams, if you are preparing for more than one or want another angle on it.
Impact of financing on investment decisions and adjusted present values: frequently asked questions
What is the adjusted present value method in AFM?
APV values a project in two parts. You find the base-case NPV as if the project were financed only by equity. Then you add the present value of financing side effects such as the tax shield, and subtract issue costs.
Why do I ungear a beta in APV questions?
The beta of a proxy company reflects its own gearing as well as its business risk. Ungearing removes the effect of financing so you are left with business risk. You can then use it to find the ungeared cost of equity for the project.
Which rate should I use to discount the tax shield?
A common approach is the pre-tax cost of debt, because the shield depends on the interest payments. Use whatever rate the question points to, and state your assumption in your answer.
How is this chapter tested in the AFM exam?
It can appear in the 50-mark Section A case study or in a 25-mark Section B question. Expect a calculation, plus discussion of the method, assumptions and a recommendation. Professional skills marks sit alongside the technical marks.