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ACCA Strategic Professional · Advanced Financial Management · International investment and financing decisions

Orchid plc is evaluating an overseas project using APV. Which treatment of the discount rate is correct for the base-case present value?

In APV, base-case operating cash flows are discounted at the ungeared cost of equity reflecting the project's business risk, because the project is first valued as if all-equity financed. Financing side effects such as tax shields are valued separately and added.

  1. ADiscount base-case operating cash flows at the ungeared cost of equity appropriate to the project's business riskCorrect
  2. BDiscount them at the parent's WACC
  3. CDiscount them at the after-tax cost of debt
  4. DDiscount them at the risk-free rate only

Explanation

APV values the project as if all-equity financed, so base-case cash flows use an ungeared cost of equity reflecting business risk. Financing side effects such as the tax shield are added separately, usually at the cost of debt.

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