Adjusted Present Value (APV)

An Alternative DCF Approach

What is APV?
The APV approach to DCF valuation determines value by adding the net present value of a project as if it were financed solely by equity plus the present value of any financing costs or benefits (the additional effects of debt)
In other words, the financing effects of debt such as the various tax shields provided by the deductibility of interest and the benefits of other investment tax credits are calculated separately. APV is often used for highly leveraged transactions such as LBOs

The WACC approach to DCF valuation determines value by adjusting the cost of capital to reflect the capital structure (and therefore financial enhancements), APV analyzes financial maneuvers separately and then adds their value to that of the business

How the APV model works APV and WACC

APV unbundles WACC i.e. unbundles components of value and treats each one separately In contrast, WACC assumes debt is rebalanced and bundles all financing side effects into the discount rate
In other words, the WACC approach involves discounting unlevered (i.e. pre-interest, but after-tax) cash flows at a rate that reflects a blend of the costs of the different sources of financing

The APV framework

Value of all financing side effects Base-case value APV = Value of the project as if it were financed entirely with equity Interest rate tax shields

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Financial distress costs Issuance costs Subsidies & guarantees Hedges

The APV framework in more detail

Value of the project as if it were financed entirely with equity
Unlever beta and recalculate WACC at zero leverage (which is equal to the cost of equity) Discount the free cash flows to the firm using the unlevered WACC Model the tax advantages of financing with debt rather than an all-equity structure One of two debt assumptions can be made:
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Interest rate tax shields

Discount the tax shield to NPV using the cost of debt (fixed debt assumption) Discount the tax shield to NPV using the zero-levered WACC, I.e. the unlevered cost of equity (rebalanced debt assumption)

Financial distress costs

Assess the probability of bankruptcy Estimate the costs of bankruptcy Calculate the costs of financial distress by multiplying the costs of bankruptcy by the probability of going bankrupt

Issuance costs

Raising equity often involves issues costs such as the issue discounts, commissions, fees and underwriting costs Although such costs are disregarded when using APV for firm valuations, there are often taken into account when APV is used to evaluate separate projects

APV Example #1

Project A has an NPV of $150,000. The Company has to issue stock, with brokerage costs of $200,000, in order to finance the project Project NPV Stock Issue Cost Adjusted NPV = $150,000 -$200,000 -$ 50,000

Conclusion: Dont do the project

APV Example #2

Project B has an NPV of -$20,000. The Company has to issue $2,314,285 of debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. The adjusted NPV of the project would then be calculated as follows: Project NPV -$20,000 Debt Issue Cost $60,000 Adjusted NPV = $40,000

Conclusion: Do the project

Tube Corp. case study: valuation using WACC

Tube Corp. is a diversified manufacturing firm located in India. In 2001, the firm reported operating income of $632.2 million. Its corporate tax rate is 30%. The firm had book value of equity of $3,432.1 million and book value of debt of $1,377.2 million at the end of 2000. The firm is in a stable industry and expects to grow only 5% a year Step 1: Estimate free cash flows to the firm The firms free cash flow to the firm next year can be estimated as follows:
Expected EBIT (1-t) next year = $632.2(1-0.30)(1.05) = $464.7

Assuming a net reinvestment rate of 54.34%: Step 2: Estimate the cost of equity

Expected free cash flow to the firm = $464.7 ($464.7)(.5435) = $212.2

If Tubes beta is 1.17, the risk free rate is 10.5% and the risk premium is 9.23%, then:
Cost of equity = 10.5% + 1.17(9.23%) = 21.30%

Tube Corp. case study: valuation using WACC (contd)

Step 3: Estimate the WACC Assume cost of debt for Tube Corp. is 12.0%, and that the market value of equity is $2,282.0 million and the market value of debt is $1,807.3 million, then: WACC = (Cost of equity) ((E/(D+E)) + (After tax Cost of Debt)((D/D+E)) = (21.3%)(0.5581) = (12.0%)(1-0.30)(0.4419) = 15.6% WACC Valuation = Value of the operating assets + Value of cash and marketable securities = [($212.2)/(0.156 - .05)] + $1,365.3 = $3,367.3 million

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Tube Corp. case study: valuation using APV

Step 1: Estimate unlevered firm value If Tubes beta is 1.17, the market value of equity is $2,282.0 million and the market value of debt is $1,807.3 million (thus its current debt to equity ratio is 79.2%) and the firms tax rate is 30%, then:
Unlevered Beta = Levered Beta____ [1+ (1-tax rate)*(D/E)] 1.17_____ = 0.75 [1+ (1-.3)(0.7921)]

Unlevered Beta =

If the risk free rate is 10.50% and there is a risk premium of 9.23%, then unlevered cost of equity:
Unlevered cost of equity = Rf + Unlevered Beta*(Market risk premium) = 10.50% + 0.75(9.23%) = 17.45%

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Tube Corp. case study: valuation using APV (contd)

If, using the same assumptions as on page 8, the free cash flows to the firm are $212.2 million and the Company is expected to grow 5% a year, the unlevered firm value using an APV valuation approach is:
Unlevered Firm value = Unlevered Firm value = Free cash flows to the firm____________ (Unlevered Cost of equity Firm growth rate) 212.2___ = $1,704.6 million (.1745-.05)

Step 2 (a): Estimate the tax benefits from debt using the fixed debt approach If the market value of Tubes existing debt is $1,807.3 million and the tax rate is 30%, then:
PV of expected tax benefits in perpetuity = (Debt)*(Interest rate on debt)*(Corp. tax rate) (rd) = Debt* Corp. tax rate = (1,807.3) * (0.30) = $542.2 million

Tube Corp. case study: valuation using APV (contd) Step 2 (b): Estimate the tax benefits from debt using the rebalanced debt approach

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In year 0, Tubes market value of debt was $1,807.3 million and the market value of equity was $2,282.0 million, thus the debt to equity ratio is 79.2% In years 1 and 2 the market value of equity increases by 5% annually, thus in order the maintain the D/E ratio of 79.2%, debt would have to increase:
Year 1: D = $1,897.7 = 79.2% E $2,396.1 Year 2: D = $1,992.6 = 79.2% E $2,515.9

Thus, the PV Tax Shield(year x) = (Debt)*(Interest rate on debt)*(Corp. tax rate) (1 + unlevered cost of equity) x
Yr. 1 = $1,897.7 * .12 * .30 = $58.2 million (1+.1745)1 Yr. 2 = $1,992.6 * .12 * .30 = $52.0 million (1+.1745)2

In year 3 (final year of projections), the market value of equity increases by 5% to $2,641,7 million thus requiring debt to increase to $2,092.2 million, thus:
Yr. 3 = $2,092.2 * .12 * .30 = $46.5 million (1+.1745)3 PV Tax Shield(year 3) = (Debt) * (Interest rate on debt) * (Corp. tax rate) (rd) (1+ re) 3 = $ 387.4 million

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Tube Corp. case study: valuation using APV (contd)

Step 3: Estimate expected bankruptcy costs To estimate, assume that based on the companys existing rating, the probability of default at the existing debt level is 10% and that the cost of bankruptcy is 40% of unlevered firm value, thus:
Expected bankruptcy cost = Prob. of bankruptcy * Cost of bankruptcy *Unlev. firm value = 0.10*.0.40*$1,704.6 = $68.2 million

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Tube Corp. case study: valuation using APV (contd)

APV Valuation, if using the fixed debt approach

= Unlevered firm value + PV of tax benefits Exp. bankruptcy costs + Val.of cash and mark. sec. = $1,704.6 + $542.2 $68.2 + $1,365.3 = $3,543.9 million

APV Valuation, if using the rebalanced debt approach

= Unlevered firm value + PV of tax benefits Exp. bankruptcy costs + Val.of cash and mark. sec. = $1,704.6 + ($58.2+$52.0+$46.5+$387.4) $68.2 + $1,365.3 = $ 3,545.8 million

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Tax shields and debt APV vs. WACC

The WACC valuation incorporates the impact of taxes by using the after-tax cost of debt in the WACC calculation. APV does this by explicitly modeling the debt balances and interest charges and calculating the NPV of all future tax shields In the APV approach, one of two debt assumptions can be made: Debt is automatically rebalanced to a constant percentage of the market value of the equity and the resulting tax shield is discounted at the unlevered cost of equity (because this level is dependent on business risk) Debt remains fixed at an absolute amount and the resulting interest tax shield is discounted The WACC approach assumes that debt is automatically rebalanced to the market value of equity. This assumption is implicit in the WACC calculation where the mix of debt and equity is based on market values rather than book values

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Costs of financial distress APV vs. WACC

The WACC approach incorporates the impact of financial distress in two ways:
By levering the beta, the impact of higher leverage is reflected by increasing the beta and through the CAPM, the cost of equity The impact of leverage will push up the interest rate which the firm must pay. The higher interest rate is to offset the increased possibility of default There is thus a theoretical optimal capital structure where the increased cost of equity and cost of debt are exactly matched by the lower cost of debt capital

In order for the APV approach to be equivalent to the WACC approach, it must incorporate a cost of financial distress, which is calculated as the probability of bankruptcy (default) multiplied by the direct and indirect costs of bankruptcy At lower levels of leverage, the effective probability of default is so low that it is not even worth calculating the costs of financial distress. Where leverage levels rise, cost of financial distress calculations become not only necessary but also informative

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Principal applications of the APV method

Valuations of project financings When there are changing debt structures Situations involving tax loss carryforwards In order to optimize debt levels As a check against other DCF valuation methods