In some cases, when valuing an organization, using the WACC method for discounting cash flows can be misleading, and it is better to use the APV method.
To understand this, it is useful to look at the modified form of WACC, where it appears as a function of the value of the Interest Tax Shield (ITS).

Specifically:

If we take the general “re-levering” formula (including preferred stock and other guarantees),


and then subtract the general WACC formula,


we arrive at the following, relatively simple formula:

Note: here the components of preferred stock and guarantees disappear, just as any other obligations would, because they do not affect the interest tax shield.

Looking at these formulas gives us the ability to see when the WACC method might mislead us.

  1. Interest and Net Operating Loss Carryforwards – Interest expenses and operating losses can cause the benefit from the interest tax shield to be delayed over time. For example, an organization may accumulate losses that in future years reduce taxable income. Therefore, the tax savings from interest expenses are shifted into the future. In such cases, it is more convenient to use the APV method to forecast ITS separately.
  2. Capitalized Interest – In some countries, in certain cases, interest expenses are capitalized and then written off through the Cost of Goods Sold. This applies to long-term projects such as civil construction, shipbuilding, etc. In such capitalization, the interest expense is fixed but not recognized in expenses, and therefore no tax savings are realized. Hence, the APV method is recommended.
  3. Paid-in-Kind Interest (zero-coupon bonds) – In some cases, interest is not paid but is accrued and recognized as an expense. Therefore, the tax shield benefit is recorded earlier in time than the actual cash interest payments.
  4. Cost of Debt vs. Effective Interest Rate – The interest tax shield is based on book values rather than market values, while the WACC formula is based on market values. If, after the debt issuance, significant changes occur in the market (e.g., inflation), book and market values can diverge. Usually, this difference is not material, but in some cases, it can be significant.

Finally, just as the general Un-lever/Re-lever formula produces four different versions depending on the company’s specifics, it is also possible to form versions of WACC (see in more detail: 4 Versions of Un-Levering Formulas), whose proper application can help avoid serious errors.

Source:
Corporate Valuation: Theory, Evidence and Practice
Mark E. Zmijewski; Robert W. Holthausen
Second Edition

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