Since the additional financing benefits are taken into account, the primary benefit of the APV approach is that the economic benefits stemming from financing and tax-deductible interest expense payments e. First, the present value PV of an unlevered firm refers to the present value of the firm, under the pretense that the company has zero debt within its capital structure i. By discounting the projected free cash flows FCFs to the firm at the unlevered cost of capital — i. Next, the financing effects are the net benefits related to debt financing, most notably the interest tax shield.
The interest tax shield is an important consideration because interest expense on debt i. Thereby, the APV approach allows us to see whether adding more debt results in a tangible increase or decrease in value, as well as enables us to quantify the effects of debt.
Note that since the APV is based on the present-day valuation, both the unlevered firm value and the financing effects must be discounted back to the current date. The APV approach shares many similarities to the DCF methodology, however, the major difference lies in the discount rate i. Unlike the WACC, which is a blended discount rate that captures the effect of financing and taxes, the APV attempts to unbundle them for individual analysis and view them as independent factors.
The WACC of a company is approximated by blending the cost of equity and after-tax cost of debt, whereas APV values the contribution of these effects separately.
But despite providing a handful of benefits, APV is used far less often than WACC in practice, and it is predominantly used in the academic setting. Below, the downloadable APV calculation template will guide you through the full calculation of APV, which consists of valuing the unlevered cash flows and the PV of the net debt financing. As for the tax rate, discount rate, and terminal value assumptions, the following assumptions are going to be used:. But recall that the APV calculation is as of the present date, thus we must discount this TV amount to the present.
As with the base case, we still need a terminal value and a discount rate. A common expedient is to use the cost of debt as a discount rate, on the theory that tax shields are about as uncertain as principal and interest payments. This suggests that tax shields are a bit more uncertain and so deserve a somewhat higher discount rate.
Others argue for an even higher discount rate, observing that managers will adjust leverage up or down according to prevailing business conditions or the fortunes of the company. If so, then future interest payments, along with the tax shields, will fluctuate for the same reasons that operating cash flows fluctuate and therefore deserve the same discount rate.
Following the most common approach, we used a rate of 9. So, too, will interest tax shields grow. We say this is an initial estimate for two reasons. First, we have ignored other financing side effects here to shorten the presentation.
And second, even within this simplified example, we can push the APV analysis further and obtain more insight. How much value does each of his planned initiatives create? Do the executives responsible for realizing that value know how much it is? Do they know what it depends on? Finally, how much of the value that is to be created will be paid over to the seller at closing?
The fifth step of an APV analysis can examine these and other managerially pertinent questions. Baseline cash flows are derived from recent operating results and represent the business in its current underperforming configuration.
Then there are increments for each of the proposed initiatives: margin improvements; net-working-capital improvements; asset liquidations; and higher steady-state growth. Both figures exclude interest tax shields. The rest comes from ongoing initiatives: improving margins and boosting growth. Most likely, those four tasks will be in the hands of different people. The rest will go to the seller as part of the sale price.
We could push the analysis still further in several ways, depending on what would help managers, negotiators, or financiers. We could examine different scenarios for each category. We could reassess tax shields to look at different proposed deal structures or to allocate debt capacity to the different parts of the business or specific initiatives.
We could reassess risk, perhaps adjusting the discount rates in the subpart valuations. Suppose, for example, that working capital improvements came primarily from liquidating excess raw-materials inventories; the associated cash flow would likely contain less business risk than normal operating cash flows and so would deserve a discount rate somewhat lower than Alternatively, suppose the margin improvements came from increased automation and, hence, higher fixed costs; this would suggest that those incremental cash flows deserve a somewhat higher discount rate.
Could these extra analytical features be performed with WACC? That would force us to think about the capital structure of, say, net-working-capital improvements. And have we expressed the debt ratio for that structure in market-value or book-value terms? Does the ratio change over time? The exercise is even more prone to error than the simple formulation in the sidebar.
APV is both less cumbersome and more informative. Unfortunately, this is not as simple a procedure as textbooks often make it appear. A sketch of the approach many companies take to this analysis highlights some of its pitfalls.
In a WACC-based analysis, we discount only once—the discount rate has to be adjusted to pick up all the costs and benefits of a selected capital structure. Not surprisingly, a lot of analytical energy goes into computing it. WACC is just what it says it is: a weighted average of the after-tax costs of different sources of capital, in which each is weighted by the fraction of the capital structure it represents. In our example, there are three kinds of debt four if you consider the refinancing in year five and one kind of equity.
See the calculations in the table above to observe how we obtained a WACC of 9. When we discount the free cash flows from this business at 9. Why the difference in estimated values? Adjusted Present Value refers to the sum of net present value of an organization or a project that is totally based on equity financing and present value of financing advantages, if any.
These financial benefits, when considered, provide tax cushions for example: deductible interest to adjusted present value. The adjusted present value tells an investor about the advantages of tax shields occurring from at least one tax deductions of interest expenses or a subsidized loan set at rates below market rates.
APV appears to be more reliable and preferable for carrying out leveraged buyout transactions. Because of the cost of capital declining with more utilization of leverage, the worth of a project financed on debt is more than the one financed on equity.
Debt, if properly used, can convert any project with a negative net present value to a positive one.
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