Which of the following statements are correct?

Because the APV method takes into account the present value of the interest tax shields, it will typically result in a higher valuation compared to the WACC method.
Under the flow-to-equity method, we discount the free cash flow to equity at the equity cost of capital.

Question

Which of the following statements are correct?

Because the APV method takes into account the present value of the interest tax shields, it will typically result in a higher valuation compared to the WACC method.
Under the flow-to-equity method, we discount the free cash flow to equity at the equity cost of capital.

BlackTom AI · Accepted Answer

The question presents two statements about valuation methods and asks which are correct. We will analyze each option in turn and explain the reasoning behind its truth value.

Option II only: This statement says that under the flow-to-equity method, we discount the free cash flow to equity at the equity cost of capital. In the flow-to-equity (FTE) approach, indeed the focus is on cash flows available to equity holders, and these are discounted at the cost of equity (the equity discount rate). This makes the statement true because the method directly targets equity cash flows and uses Ke as the discount rate. If evaluated in isolation, this option would be considered correct.

Option I only: This statement claims that the APV (Adjusted Present Value) method will typically result in a higher valuation compared to the WACC method because APV takes into account the present value of the interest tax shields. APV does separate the value of operations from the value of financing side effects; it adds the PV of tax shields from debt to the base case value (often computed with all-equity financing). This means APV incorporates the tax shield benefit explicitly, which often increases the overall valuation relative to a plain WACC approach that blends operating and financing effects into a single discount rate. However, the word “typically” introduces nuance: the degree to which APV exceeds or falls short of the WACC valuation can depend on the amount of debt, tax rates, and other financing assumptions. In many common scenarios with non-trivial debt, APV tends to be higher than a WACC valuation, but not universally in every possible case. The statement, while generally plausible, is not universally guaranteed in all situations, so as a strictly true statement it requires cautious acceptance.

Option none: This would imply that neither statement I nor II is correct. Given the analysis above, Statement II is correct, so this option is false.

Option I and II: This option asserts that both statements are correct. Given that Statement II is correct and Statement I is typically correct (with the caveat about the dependency on financing structure and assumptions), the combination that both are correct is valid in standard practice. This aligns with common teaching that APV captures tax shields and often yields a higher valuation than WACC, while FTE discounts equity cash flows at Ke.

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