Is APV Better Than WACC for Non-Stationary Debt Ratio?

Abstract

The WACC method is normally considered suitable for firms maintaining a constant debt ratio; while the APV method is more convenient when debt policy and tax rate are more complex. However, we show that this is incorrect in that the APV method actually requires knowledge about more variables (than the WACC method does) in order to implement accurately. On top of this, the central issue (with the APV method) regarding the discount rate for the tax shields is still an open question to a large extent, which makes the APV method even more unreliable. The two-year example provided in this study is set up in a style as general as possible. This allows for an easy extension to more general and realistic situations. Therefore, we clarify a widespread yet mistaken notion about the WACC and the APV method. Not only does it correct a longstanding misconception in academics, but it also has useful implications in practice.