Search the wiki
»

Modified on 2011/08/08 13:55 by swathen Categorized as Uncategorized
Cost of Capital Funding
Arbitrage Pricing Theory
Capital Asset Pricing Model
Capital Budgeting Methods
Required Rate of Return

Adjusted present value (APV), defined as the net present value of a project if financed solely by equity plus the present value of financing benefits, is another method for evaluating investments. It is similar to NPV. The difference is that is uses the cost of equity as the discount rate rather than WACC. And APV includes tax shields such as those provided by deductible interests. APV analysis is effective for highly leveraged transactions.

The adjusted present value approach can be explained as working very similar to the Discounted Cash Flow method of valuation. So similar, in fact, that they will yield approximately the same results if the financing structure of a company is consistent. The method is especially effective in any situation in which the tax implications of a deal heavily effect the outcome, such as with a leveraged buyout. The adjusted present value method is newly created when compared to the more common methods of valuation.

The formula for adjusted present value is:
NPV (of a venture financed solely with equity capital) + PV of financing

## APV Calculation¶

In the adjusted preset value (APV) approach the value of the firm is estimated in following steps.

1. The first step is to estimate the value of a company with no leverage by calculating a NPV at the cost of equity as the discount rate.

2. The next step is to calculate the expected tax benefit from a given level of debt financing. These can be discounted either at the cost of debt or at a higher rate that reflects uncertainties about the tax effects. The NPV of the tax effects is then added to the base NPV.

3. The last step is to evaluate the effect of borrowing the amount on the probability that the firm will go bankrupt, and the expected cost of bankruptcy.

In the adjusted present value (APV) approach, the primary benefit of borrowing is a tax benefit and that the most significant cost of borrowing is the added risk of bankruptcy.

If:
Investment = \$500,000
Cashflow from equity = \$25,000
Cost of equity = 20%
Cost of Debt = 7%
Interest on debt = 7%
Tax = 35%
And the deal is financed half with equity and half with debt

NPV = -\$500,000 + (\$25,000 / 20%) = -\$375,000
PV = (35% x \$250,000 x 7%) / 7% = \$87,500

-\$375,000 + \$87,500 = -\$287,500 --> Bad Deal

## APV Valuation vs Cost of Capital¶

In an APV valuation, the value of a levered firm is obtained by adding the net effect of debt to the un-levered firm value.

In the cost of capital approach, the effects of leverage show up in the cost of capital, with the tax benefit incorporated in the after-tax cost of debt and the bankruptcy costs in both the levered beta and the pre-tax cost of debt.

In theory, these two approaches can get the identical results. The first reason for the differences is that the models consider bankruptcy costs very differently, with the adjusted present value approach providing more flexibility in considering indirect bankruptcy costs whether or not it shows up in the pre-tax cost of debt. So the APV approach will yield a more conservative estimate of value. The second reason is that the APV approach considers the tax benefit from a dollar debt value, usually based upon existing debt. The cost of capital approach estimates the tax benefit from a debt ratio that may require the firm to borrow increasing amounts in the future.