Investment appraisal : a critical review of the adjusted present value (APV) method from a South African perspective

Abstract

Since first developed by S C Myers, the adjusted present value (APV) approach has gained wide recognition as an acceptable method of discounting cash flows. Although a number of assumptions have to be made, there is merit in using the APV method as an alternative to the NPV method of project appraisal. The purpose of this article is to evaluate the appropriateness of the APV method for investment appraisal purposes in the South African context. The major advantage of the APV method is that it separates the NPV rendered by the project if it were all-equity financed, from the side-effects of financing. This allows the advantage of project-specific financing to be taken into account in a very direct way when a project is evaluated, which is especially helpful when the weight or cost of financing differs from the rest of the company. Within the South African context, and specifically against the background of South African taxation legislation, certain principles underlying APV is questionable. The major point of critique is that the existence of the tax shield under South African taxation legislation is not proven. The second point of critique is that the different formulae used to determine the K„, the cost of equity in an ungeared project, only render the same answer when the cost of debt is equal to the risk-free rate. In this regard a suggestion is made to adjust K„ for the premium on the risk-free rate in the case where the cost of debt exceeds the risk-free rate.