Discuss the adjusted present value, the flow to equity, and the weighted average cost of capital methods of capital budgeting with leverage and the guidelines for using each method.
What will be an ideal response?
The adjusted present value is defined as the value of the project to the unlevered firm plus the net present value of financing side effects. There are four side effects: the tax subsidy of debt, the costs of issuing new securities, the costs of financial distress, and subsidies to debt financing. The flow to equity approach is an alternative to adjusted present value. It is the discounted cash flow from a project to the equityholders of the levered firm at the cost of equity. Finally, the weighted average cost of capital approach considers the firm that is financed with both debt and equity and allocates the costs proportionally for each capital component. Essentially, the manager should use the WACC or FTE if the firm's target debt-to-value ratio applies to the project over its life. Alternatively, one should use APV if the project's level of debt is known over the life of the project.
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