Sampa Video Case Study
The NPV of the project entirely equity financed is $1,228.
The appropriate discounted rate is 15.8%.
The APV of the project assuming the firm uses fixed debt of $750 thousand and keeps the level of debt constant in perpetuity is $1,528.
The NPV of the project using after-tax WACC and assuming a constant 25% target debt-to-value ratio in perpetuity is $1,470.
Answer 1 – 3, please see attached spreadsheet for calculations.
25% debt balances at year end imply interest tax shield.
The value of APV is higher than the value of WACC. Because APV method doesn't have to hold debt ...view middle of the document...
And it makes sense to assume a constant debt ratio because the debt capacity of the project must depend on its future value, which will fluctuate.
However, if Sampa decides to use fixed amount of debt to fund the project they should use the APV approach to value the project. Because it is more convenient to value to firm when level of debt has no relationship with the firm's value. APV gives the financial manager an explicit view of the financial side effect such as interest tax shield (the most important), cost of securities and financing subsidized that are adding or subtracting the value.
Assume that financing doesn't matter. APV is recommended to use within the horizon when no fixed ratio is necessary. The firm as a whole is valued without consideration to its leverage over time leaving the level of debt as an independent variable with no relation to the value of the firm. Also, the present value of the debt tax shield is obtained by discounting actual tax rate without assuming a constant corporate tax rate.
It assumes that financing matters because of interest tax shields. WACC will be preferred when debt is rebalanced to keep a constant ratio of debt to market value. The level of debt evolves with the value of the firm. So, tax savings depend on both the changing value of the firm and the discount rate of debt.