Adjusted NPV (APV)

Interrelationship between the Investment and

Financing Aspects

• WACC is the right discount rate for a project that is a carbon

copy of the firm’s existing business.

• A project may have financing effects that differ from those of

the existing investments of the firm. It may have a different
debt capacity or be entitled to certain subsidies or have some
special financial features. In such cases the recommended
method is to calculate the adjusted NPV (or APV for short).
 Adjusted Present Value (APV)
APV = Base-case NPV + PV of the positive and negative financing
side effects of the project.

The base-case NPV is the NPV of the project under the following
assumptions:
• The project is financed entirely by equity.
• There is no financing side effect like issue cost or subsidy
The present value of financing side effects is equal to:
• Present value of positive financing side effects like tax
shield on debt and availability of subsidies.
• Present value of negative financing side effects like issue
costs and financial distress costs associated with excessive
leverage.
Numerical Example: APV
• Parimala Company is considering a project requiring Rs. 5
million of investment. It is expected to generate a net cash
flow of Rs. 1 million per year for 8 years. The opportunity
cost of capital is 15% - this reflects the return required by
equity investors, assuming that the project is entirely
funded by equity. The cost of issuing equity is 5%. The
project enables the firm to raise Rs. 2.4 million of debt
finance. The debt will carry a rate of interest of 14% and
will be repaid in equal annual installments over a period of
8 years. The tax rate is 40%. Calculate APV
 Illustration
Investment
Net cash inflow
Opportunity cost of capital
Issue cost of equity
Debt available
Repayment of debt
Tax rate
: Rs. 5 million
: Rs.1 million per year for 8
years
: 15 percent
: 5 percent
: Rs.2.4 million at 14 percent
: 8 equal annual instalments.
First instalment will be paid at
the end of first year
: 40 percent
 Illustration

(i) Base – case NPV:

8 1,000,000
-5,000,000 +  = -512,700
t=1 (1.15)t
(ii) APV

To calculate APV, the base-case NPV has to be adjusted for two

factors: (i) issue cost, and (ii) tax-shield associated with debt.
(a) Issue cost:
Out of the total financing requirement of the project Rs.2,600,000
will come from the equity sources and Rs.2,400,000 will come in
the form of debt finance.
As the net equity finance required by the project is Rs.2,600,000
and the issue costs would absorb 5 per cent of the gross proceeds
of the issue, the firm will have to issue Rs.2,736,842
(Rs.2,600,000 / 0.95) of equity stock in order to realise a net
amount of Rs.2,600,000.
The difference of Rs.136,842 is the cost of underwriting,
brokerage, printing, and other issue related expenses. The APV
after adjustment for issue cost is :
APV = Base-case NPV – Issue cost
= -Rs.512,700 – Rs.136,842
= -Rs.649,542
Now we consider the adjustment for the tax shield associated with
debt finance. (APV.xls) The present value of tax shield associated
with Rs.2,400,000 of debt finance is calculated. From this we find
that the debt finance associated with the project brings a stream of tax
shields which has a present value of Rs.403,385. If we make
adjustment for this also, we get :

APV = Base case NPV – Issue cost + Present

value of tax shield
= -Rs.512,700 – Rs.136,842 + Rs.403,385
= -Rs.246,157
 Calculation of the Present Value of Tax Shield

Year Debt outstanding Interest Tax shield Present value of

at the beginning tax shield
(at 14% discount rate)

1 2,400,000 336,000 134,400 117,869

2 2,100,000 294,000 117,600 90,552
3 1,800,000 252,000 100,800 68,040
4 1,500,000 210,000 84,000 49,728
5 1,200,000 168,000 67,200 34,877
6 900,000 126,000 50,400 22,982
7 600,000 84,000 33,600 13,440
8 300,000 42,000 16,800 5,897

Total Rs.403,385
• Vayu Vidyut Case Study 7 VAYUVIDYUT.pdf
 Merits of APV

The principle underlying APV is to divide and conquer. APV does

not reflect the side effects of financing in a single calculation.
Instead, it captures them in a series of calculations. This makes it
more illuminating. You not only know what the APV is but also
where it is coming from. This is helpful in reformulating the project.

APV makes more sense for projects that have a capital

structure that is different from the rest of the firm or which have a
capital structure that changes significantly over time or which enjoy
special concessions, incentives, and subsidies. For example, APV is
eminently suitable for leveraged buyouts(LBOs) or infrastructure
projects.
 Cost of Capital
Though conceptually sound, APV is not very popular because

(i) it requires some sophistication to assess the financing side effects,

and (ii) it involves a series of adjustments which may be cumbersome.

That is why WACC, which is the cost of capital adjusted for financing
effects, is more commonly used in practice. Recall that WACC is:

D E
rD (1- Tc) + rE
V V