Introduction
Capital budgeting is a crucial process for companies, as it involves making important investment and financing decisions that directly impact their growth and profitability. These decisions are interconnected and play a vital role in determining the optimal capital structure for an organization. Let's explore the interaction between investment and financing, review the concept of leverage without tax shield, explore leverage with tax shield, and examine the Adjusted Present Value (APV) and Weighted Average Cost of Capital (WACC) methods for capital budgeting. Lastly, we will compare APV and WACC to help you choose the best approach for your business.
Interaction between Investment and Financing
Investment and financing decisions are two sides of the same coin, as they both deal with the allocation of resources to generate returns. Investment decisions involve selecting projects that yield positive net present values, while financing decisions pertain to raising the required capital for those projects through equity, debt, or a combination of both. The interaction between these decisions is essential in determining a company's overall value and financial health.
Leverage without Tax Shield (Review)
Leverage, in a financial context, refers to the use of borrowed funds to increase the potential return on an investment. As we discussed in the previous blog post Financing Decisions and Capital Structure, under the assumptions of Modigliani-Miller Irrelevance Theory where no frictions exist in the market, leverage ratio does not impact firm valuation.
When company's D/E ratio changes, the overall cost of capital for the entire firm is not impacted. The assets alone determine the asset cost of capital. However, the equity cost of capital will change under the Modigliani-Miller assumptions when the D/E ratio changes. So an increase in the D/E ratio, meaning an increase in debt or a decrease in equity, would result in an increase in the equity cost of capital while the asset cost of capital would remain constant. The debt interest rate may or may not change under these circumstances.
When a tax shield is present, such as under the US tax code that allows firms to deduct interest payments, the tax shield can reduce the tax liability of the firm and allow passing that credit to the shareholders. Therefore, such a tax shield can increase the value of a firm.
Leverage with Tax Shield: APV and WACC with Tax Shield
As presented above, when considering the tax implications of debt financing, the interest expense on debt becomes tax-deductible, creating a tax shield. Two popular methods for incorporating the tax shield in capital budgeting or valuation efforts are the Adjusted Present Value (APV) and the Weighted Average Cost of Capital (WACC) approaches.
Implementing APV
The APV method involves estimating the net present value (NPV) of a project under two scenarios: unleveraged and leveraged. The unleveraged NPV is calculated using the project's cash flows and the firm's unleveraged cost of capital. The tax shield's present value is then calculated using the tax rate and the cost of debt. The APV is the sum of the unleveraged NPV and the present value of the tax shield. Projects with positive APVs are deemed worthwhile investments.
\begin{equation} \begin{aligned} \text{PV}_L &= E + D \\ &= \text{PV}_U + \text{PVTS} - \text{PVDC} \\ &= \sum\limits_{t=1}^{\infty} \frac{(1-\tau)X_t}{(1+r_A)^t} + \text{PVTS} - \text{PVDC} \end{aligned} \end{equation}
- \( \text{PV}_L \): Present value of a leveraged firm
- \( E \): Equity
- \( D \): Debt
- \( \text{PV}_U \): Value of the unlevered firm
- \( \text{PVTS} \): Present value of the tax shield
- \( \tau \): Corporate tax rate
- \( r_A \): Asset cost of capital
- \( \text{PVDC} \): Present value of the default costs
- \( X_t \): Total terminal pretax cash flow at time \(t\)
It should be noted that the discount rate used for the PVTS and PVDC depends on the risk of the debt. If the debt is generally fixed and not changing over time, it likely is ok to use the cost of debt for the discount rate. But if the firm regularly rebalances to keep a constant D/E ratio, then it likely is more appropriate to discount the debt by the asset cost of capital.
Another interesting aspect of APV is that other tax shields, such as depreciation, can be added into the formula/process to gain a potentially more accurate valuation.
Implementing WACC
The WACC approach incorporates the tax shield directly into the firm's cost of capital. It calculates the weighted average of the after-tax costs of debt and equity. The WACC is then used to discount the project's cash flows to obtain its NPV. Similar to the APV method, projects with positive NPVs are considered attractive investments.
\(PV_L = \sum\limits_{t=1}^{\infty} (1-\tau) \cdot \frac{X_t}{(1+WACC)^t}\)
\(WACC = \frac{D}{(D+E)} \cdot (1-\tau) \cdot r_D + \frac{E}{(D+E)} \cdot r_E\)
\(WACC = w_D \cdot (1-\tau) \cdot r_D + w_E \cdot r_E\)
- \(PV_L\): Present value of a leveraged firm
- \(E\): Equity
- \(D\): Debt
- \(\tau\): Corporate tax rate
- \(X_t\): Total terminal pretax cash flow at time t
- \(WACC\): Weighted average cost of capital
- \(w_D\): Weight of debt in the firm
- \(w_E\): Weight of equity in the firm
- \(r_D\): Cost of debt
- \(r_E\): Cost of equity
APV versus WACC
While both APV and WACC approaches account for the tax shield, they differ in their assumptions and complexity. The APV method is more flexible, as it allows for varying levels of debt, but it requires separate calculations for the unleveraged NPV and the tax shield. On the other hand, some believe that the WACC is more straightforward. The choice between APV and WACC depends on the firm's specific circumstances, such as its financing policy and the complexity of its capital structure.
Numerous studies and surveys indicate that the Weighted Average Cost of Capital (WACC) method is the preferred choice for valuation across various industries in comparison to the Adjusted Present Value (APV) approach. Despite this preference, it is essential for business professionals and financial analysts to carefully consider the advantages offered by the APV method, given its inherent flexibility and absence of certain restrictive assumptions.
The APV method offers several benefits that can lead to more accurate and insightful valuations.
No Constant Debt Assumption: APV does not necessitate the assumption of a constant debt ratio, as is the case with the WACC method. This is a significant advantage because debt ratios can vary over time, influenced by factors such as market conditions, business strategies, and regulatory changes. By not requiring this assumption, the APV method provides a more realistic representation of a company's value and potential for growth.
Value Attribution: APV is often considered superior to the WACC for attributing value to assets, liabilities, tax shields, costs of default, depreciation, and other financial factors. APV separates the value of a project or firm into its unleveraged (base) value and the value of financing side effects, such as tax shields and bankruptcy costs. This allows for a more precise analysis of individual components, making it easier to account for complex financial structures and various scenarios. In contrast, WACC blends the cost of debt and equity into a single discount rate, which may obscure the specific impact of individual financial factors.
Flexibility: The APV method can be particularly useful for businesses with complex capital structures or those undergoing significant changes in their financial positions such as the case in leveraged buyouts or startup companies. For instance, startups or companies experiencing rapid growth may have irregular financing patterns, making the WACC method less suitable for accurate valuation. In such cases, the APV method can provide a more reliable and informative assessment of the firm's value in that it accurately captures the effects of changing debt levels and financing structures throughout the investment period. This flexibility enables investors to better evaluate the impact of different financing strategies on the overall value of the target company, leading to more informed decision-making.
However, under the right circumstances for a particular use case it may not matter if APV or WACC is used if it is applied properly/correctly with all things considered.
Conclusion
Investment and financing decisions are vital components of capital budgeting, and understanding the role of leverage and tax shields is critical to making informed choices. Both the APV and WACC methods have their merits, and the best approach for your organization will depend on the specific circumstances and preferences. By carefully considering the interaction between investment and financing, and incorporating the tax shield through either the APV or WACC method, you can make more informed decisions that will contribute to the growth and success of your company. Ultimately, adopting a comprehensive and well-thought-out capital budgeting process will enable your organization to allocate resources effectively, manage risks, and enhance shareholder value.