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Advanced Financial Management · Impact of financing on investment decisions and adjusted present values

Debt Capacity and Project Financing Assumptions in APV

Updated 11 October 2026 · Fact-checked

Debt capacity is the amount of debt a project can support, usually a stated percentage of project value or cost. In APV you multiply that debt by the interest rate and the tax rate to get each year's tax shield. You discount the shields at the pre-tax cost of debt and add them to the base-case NPV.

Understand Debt Capacity and Project Financing Assumptions

APV values a project in two parts. First you find the base-case NPV, as if the project were funded entirely by equity. Then you add the value of financing side effects. The biggest side effect is usually the tax shield on debt interest.

To value the tax shield you need to know how much debt the project carries. That is debt capacity: the debt the project can support, not what the company happens to borrow. Exam questions state it as a percentage of the project's initial cost, of the project's value, or of the asset's value. They may also give a fixed amount of debt for a set number of years.

The tax shield exists because interest is tax deductible. Each year the saving is interest × tax rate. You discount it at the pre-tax cost of debt, because the shield is about as risky as the debt payments that create it. Do not use the WACC. The WACC already includes the tax benefit, so using it double counts.

The financing assumption you choose drives the answer. Debt held for the full project life gives a larger shield than debt repaid early. Debt that moves with the project's value gives a shield that falls as value falls. Always state your assumption, because the examiner marks the reasoning as well as the number.

In the Section A case you also need to comment. Debt capacity is an estimate, tax relief needs taxable profits to use it, and a high debt level raises financial distress risk. A good answer links the number to a recommendation.

Key rules to remember

APV
APV = base-case NPV + PV of financing side effects
Base-case NPV uses the ungeared cost of equity. Side effects include the tax shield, issue costs and subsidised loan benefits.
Debt capacity
Debt = debt capacity % × stated base (initial cost or project value)
Use the base the question names. If it gives the debt amount directly, use that.
Annual interest
Interest = debt outstanding × pre-tax interest rate
Use the debt outstanding at the start of the period unless told otherwise.
Annual tax shield
Tax shield = interest × tax rate
Count it only in years when the tax relief is actually received. Follow any stated tax lag.
PV of tax shield
PV = Σ tax shield ÷ (1 + Kd)^t
Kd is the pre-tax cost of debt, or the risk-free rate if the question tells you to use it.
Permanent debt shortcut
PV of tax shield = debt × tax rate
Applies only if debt is permanent and discounted at the same rate as the interest rate.
After-tax issue costs
Issue cost × (1 − tax rate) if tax deductible
Deduct from APV. If the question says issue costs are not deductible, deduct them in full.

How to solve Debt Capacity and Project Financing Assumptions questions

Use this order for any APV question that involves debt capacity or a financing assumption.

  1. 1Calculate the base-case NPV using the ungeared cost of equity. Keep it separate from the financing effects.
  2. 2Find the debt capacity. Identify the base the question uses (initial cost, project value or asset value) and apply the percentage.
  3. 3Decide the debt profile year by year. Is the debt constant, repaid at the end, or linked to a falling project value? State the assumption.
  4. 4Calculate interest each year on the debt outstanding, using the pre-tax rate.
  5. 5Multiply by the tax rate to get the tax shield. Place it in the correct years, allowing for any tax lag and the project life.
  6. 6Discount the shields at the pre-tax cost of debt. Subtract issue costs, and add any subsidised loan benefit.
  7. 7Add the total side effects to the base-case NPV to get the APV. Accept the project if APV is positive.
  8. 8Write a short comment on the assumptions, the risk of the debt level and whether the tax relief is usable.

Quickest way: Tax shield table method

When to use it: Use it when debt changes over several years and you must show the working quickly.

  1. Set up a four-row table with a column for each year: opening debt, interest, tax shield, discounted shield.
  2. Fill opening debt first, using the debt capacity rule. Everything else follows from that row.
  3. Calculate interest, then multiply by the tax rate in one step if you are short of time (debt × rate × tax).
  4. Discount each shield at Kd and sum the row.
  5. Deduct issue costs and add the result to the base-case NPV. Finish with one line of comment.

Common mistakes in Debt Capacity and Project Financing Assumptions

  • Discounting the tax shield at the WACC

    The WACC is the usual discount rate in NPV, so students use it by habit.

    Fix: Use the pre-tax cost of debt for the shield, unless the question gives another rate. The WACC already contains the tax benefit.

  • Multiplying the whole debt by the tax rate each year

    Students confuse the debt balance with the interest cost.

    Fix: The annual shield is debt × interest rate × tax rate. Only the permanent-debt shortcut gives debt × tax rate, and it needs a perpetuity.

  • Using the debt the company actually raises instead of the project's debt capacity

    Students see a financing figure in the question and grab it.

    Fix: Read the wording. If the question says the project supports a percentage of value or cost, use that. If it gives the debt amount directly, use it.

  • Continuing the tax shield after the project ends

    Students assume debt stays in place without checking the project life.

    Fix: Stop the shield when the debt is repaid or the project finishes, unless the question states the debt is permanent.

  • Forgetting issue costs or the tax treatment of them

    Students treat issue costs as a minor detail and leave them out of the final sum.

    Fix: Add an issue cost line to the APV table every time. Check whether it is tax deductible.

  • No comment on the financing assumptions

    Students stop once the APV is calculated.

    Fix: Add a short comment: debt capacity is an estimate, profits must be sufficient to use the relief, and high gearing raises distress risk. Section A rewards this.

Worked examples

Example 1

A project costs $8m now. Base-case PV of operating cash flows, at the ungeared cost of equity, is $9.2m. Debt capacity is 50% of the initial cost, held for 4 years and then repaid. Pre-tax cost of debt is 6% and the tax rate is 25%. Issue costs are 2% of the debt raised and are not tax deductible. Calculate the APV.

Show the solution
  1. Base-case NPV = 9.2 − 8.0 = $1.2m.
  2. Debt capacity = 50% × 8.0 = $4.0m, constant for 4 years.
  3. Annual interest = 4.0 × 6% = $0.24m.
  4. Annual tax shield = 0.24 × 25% = $0.06m.
  5. Discount factor for 4 years at 6%: annuity = (1 − 1.06^-4) ÷ 0.06 = 3.4651.
  6. PV of tax shield = 0.06 × 3.4651 = $0.2079m.
  7. Issue costs = 2% × 4.0 = $0.08m, deducted in full.
  8. APV = 1.2 + 0.2079 − 0.08 = $1.3279m.

Answer: APV is about $1.328m. It is positive, so the project adds value and should be accepted on this basis.

Example 2

A 3-year project has a base-case NPV of $0.9m. Debt capacity is 40% of the project's value at the start of each year. Opening project values are $10m (year 1), $8m (year 2) and $5m (year 3). Interest is paid at each year end on opening debt at 5% pre-tax. The tax rate is 30%, relief is received in the same year, and the shield is discounted at 5%. Issue costs are $0.05m. Calculate the APV.

Show the solution
  1. Opening debt: year 1 = 40% × 10 = $4.0m; year 2 = 40% × 8 = $3.2m; year 3 = 40% × 5 = $2.0m.
  2. Interest at 5%: $0.20m, $0.16m, $0.10m.
  3. Tax shield at 30%: $0.060m, $0.048m, $0.030m.
  4. Discount at 5%: 0.060 ÷ 1.05 = 0.0571; 0.048 ÷ 1.1025 = 0.0435; 0.030 ÷ 1.157625 = 0.0259.
  5. PV of tax shield = 0.0571 + 0.0435 + 0.0259 = $0.1266m.
  6. APV = 0.9 + 0.1266 − 0.05 = $0.9766m.

Answer: APV is about $0.977m. The shield falls each year because debt capacity follows the declining project value, so the shield adds about $0.127m before issue costs.

Exam tips

  • Underline the base for the debt capacity percentage in the question, whether it is cost, project value or asset value, before you calculate.
  • Show the year-by-year table even for simple cases. If you slip on one number, you still earn method marks.
  • State your assumptions in one line each: debt profile, discount rate for the shield, and tax timing. These are often marked.
  • In the Section A case, link the result to risk: debt level, whether profits support the tax relief, and effect on the group's gearing. This earns professional skills marks.
  • Keep the base-case NPV and the financing effects visibly separate in your answer so the examiner can award marks for each part.

Practice questions from Impact of financing on investment decisions and adjusted present values

Debt Capacity and Project Financing Assumptions in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Debt Capacity and Project Financing Assumptions: frequently asked questions

What is debt capacity in APV?

It is the amount of debt the project can support, usually given as a percentage of the project's cost or value. You use it to work out interest and then the tax shield. It is not the same as the borrowing the company actually decides to raise.

Which discount rate do I use for the tax shield?

Use the pre-tax cost of debt, unless the question tells you to use another rate such as the risk-free rate. The shield is about as risky as the debt payments behind it. Do not use the WACC.

How do I calculate the tax shield on debt?

Multiply the debt outstanding by the interest rate to get interest. Then multiply by the tax rate. Do this for each year the debt is in place, and discount each year's shield.

What if the debt is permanent?

If debt is permanent and the shield is discounted at the interest rate, the PV of the tax shield is debt × tax rate. Only use this when the question states the debt is permanent or perpetual.