Adjusted Present Value Definition¶

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 APV approach to DCF (discounted cash flow) 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.
Adjusted Present Value Explanation¶
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.

Adjusted Present Value Formula¶

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

The APV Framework

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. 

Principal applications of the APV method

1. Valuations of project financings
2. When there are changing debt structures
3. Situations involving tax loss carry forwards
4. In order to optimize debt levels
5. As a check against other DCF valuation methods

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. 

Adjusted Present Value Example¶

Joey owns a small chemical plant called Chemco. Chemco, despite the effects of the recent recession,
is doing fine. Chemco is doing so well, in fact, that they have excess cash. Chemco decides to look for
a suitable investment for the free cash flow of the company.

The next day Joey attends his trade organization meeting. At this meeting he meets the CEO of
Chemicalventures, his main competitor to Chemco. They resolve to set aside their differences and
meet for lunch. At this lunch meeting, Joey finds out that Billy has decided to sell Chemicalvenutres
and wonders if Chemco would be interested in purchasing Chemicalventures. Billy assures Joey that
the investment will be worth his time and effort.

Joey, the next day, contacts his board of directors. The board of directors of Chemco is interested in
the idea as long as it is financed with debt. First, however, they require the financials of the company
as well as the Adjusted present value of the deal.

Joey talks to Billy, who sends the company financials over to Joey. Joey begins his preliminary
research by Googling "adjusted present value calculator". Unsatisfied with what he sees, Joey sends
the Chemicalventures financials over to his top financial analyst.

The analyst performs this calculation based on the Chemicalventures financials:

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

http://www.wikicfo.com/Wiki/Default.aspx?Page=APV
%20Valuation&NS=&AspxAutoDetectCookieSupport=1

The method is to calculate the NPV of the project as if it is all-equity financed (so called base case). Then
the base-case NPV is adjusted for the benefits of financing. Usually, the main benefit is a tax
shield resulted from tax deductibility of interest payments. Another benefit can be a subsidized borrowing
at sub-market rates. The APV method is especially effective when a leveraged buyout case is considered
since the company is loaded with an extreme amount of debt, so the tax shield is substantial.

http://en.wikipedia.org/wiki/Adjusted_present_value
(article)

http://www.ds-finance.com/APV.pdf

http://www.wisegeek.com/what-is-adjusted-present-value.htm