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

In an APV appraisal, which statement best describes the correct treatment of debt capacity?

The tax shield is based on the debt capacity the project supports, not the particular loan raised. It is added to the all-equity base-case NPV as a financing side effect and is normally discounted at the cost of debt.

  1. AThe tax shield is based on the debt the project can support, not the actual funding raised, and it is added to the base-case NPV that assumes all-equity financing.Correct
  2. BThe tax shield is based on the specific loan actually used to fund the project, and it is discounted at the ungeared cost of equity.
  3. CDebt capacity is deducted from the base-case NPV because borrowing increases financial risk.
  4. DDebt capacity is ignored in APV because the base-case NPV already includes the tax relief on interest.

Explanation

APV starts with a base-case NPV as if all-equity financed, then adds the financing side effects. The tax shield is calculated on the project's debt capacity, typically a proportion of its value or assets. It is normally discounted at the cost of debt, not the ungeared cost of equity.

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