Adjusted Present Value (APV) Model of Valuation

The Adjusted Present Value (APV) model is a powerful tool in corporate finance used to value
companies or projects. The APV method separates the value of a project or a company into two
components: the value of the project if it were all-equity financed, and the present value of financing
side effects, such as tax shields from debt.

Key Concepts of APV

1. Base Case NPV (Net Present Value): The value of the project if it were financed entirely by
equity.

2. Financing Effects: The net present value of the benefits and costs of financing, including tax
shields, issuance costs, bankruptcy costs, and other financing side effects.

Formula

The APV can be expressed as follows:

APV=NPV+PV(Financing Effects)

Where:

 NPV is the net present value of the project as if it were all-equity financed.

 PV(Financing Effects)

Detailed Breakdown

1. Calculating the Base Case NPV

The base case NPV is calculated using the project's free cash flows (FCFs) discounted at the unlevered
cost of equity (also known as the opportunity cost of capital). The formula for free cash flows is:

FCF=EBIT×(1−Tax Rate)+Depreciation−Capital Expenditures−ΔNet Working CapitalFCF = EBIT \times (1

- \text{Tax Rate}) + \text{Depreciation} - \text{Capital Expenditures} - \Delta \text{Net Working
Capital}FCF=EBIT×(1−Tax Rate)+Depreciation−Capital Expenditures−ΔNet Working Capital

Where:

 EBIT is the earnings before interest and taxes.

 Tax Rate is the corporate tax rate.

 ΔNet Working Capital is the change in net working capital.

The NPV of these free cash flows is calculated as:

NPV=∑FCFt(1+ru)^t

Where:

 ru is the unlevered cost of equity.

 t is the time period.

2. Present Value of Financing Effects

This component captures the value effects of financing decisions, primarily the tax shield from debt,
but also other effects such as flotation costs and financial distress costs.

Tax Shields

The most common financing effect is the interest tax shield. Interest expenses on debt are tax-
deductible, reducing the overall tax burden. The present value of the interest tax shield is calculated
as:

PV(Tax Shield)=∑T×rd×Dt(1+rd)t

Where:

 T is the corporate tax rate.

 rd is the cost of debt.

 Dt is the amount of debt in period t.

If debt levels are expected to remain constant, a simplified formula can be used:

PV(Tax Shield)=T×D

Other Financing Effects

Other effects to consider include:

 Issuance Costs: The costs associated with issuing new equity or debt.

 Financial Distress Costs: The costs associated with the risk of bankruptcy or financial
distress.

 Subsidies or Guarantees: Any government subsidies or guarantees that affect financing.

The present value of these effects is added to the base case NPV to arrive at the APV.

Advantages of the APV Model

1. Flexibility: The APV model allows for a clear separation between operating performance and
financing decisions, providing flexibility in analyzing complex financing structures.

2. Explicit Treatment of Financing Effects: By isolating financing effects, the APV model
explicitly accounts for the value impact of tax shields, issuance costs, and financial distress,
offering a more nuanced valuation.

3. Applicability to Leveraged Transactions: The APV model is particularly useful for highly
leveraged transactions, such as leveraged buyouts (LBOs), where financing effects are
significant.

Limitations of the APV Model

1. Complexity: The APV model can become complex, especially when dealing with multiple
financing effects and dynamic debt levels.

2. Estimation Challenges: Estimating the unlevered cost of equity and the various financing
effects can be challenging and subjective.
 3. Sensitivity to Assumptions: The APV model is sensitive to assumptions about future cash
flows, tax rates, cost of debt, and other inputs.

Practical Application and Comparison with Other Valuation Models

Comparing APV with NPV and WACC

Net Present Value (NPV) Method:

 The NPV method discounts free cash flows at the weighted average cost of capital (WACC).

 It combines operating performance and financing effects into a single discount rate.

 Simplified but less transparent in distinguishing operating performance from financing

decisions.

Weighted Average Cost of Capital (WACC):

 The WACC method uses a single discount rate that reflects the overall cost of capital,
combining the cost of equity and after-tax cost of debt.

 Useful for valuing companies with stable capital structures.

 Less transparent in isolating financing effects compared to APV.

Adjusted Present Value (APV):

 Separates operating performance (base case NPV) from financing effects, providing clarity
and flexibility.

 Particularly useful for projects with significant and dynamic financing effects.

 More complex and detailed than NPV and WACC methods.

Practical Steps in APV Valuation

1. Estimate Free Cash Flows (FCFs): Project the free cash flows of the company or project.

2. Determine Unlevered Cost of Equity: Estimate the unlevered cost of equity, reflecting the
risk of the business without considering debt.

3. Calculate Base Case NPV: Discount the free cash flows at the unlevered cost of equity to
obtain the base case NPV.

4. Identify Financing Effects: Identify and quantify the financing effects, including tax shields,
issuance costs, and financial distress costs.

5. Discount Financing Effects: Discount the financing effects to their present value using
appropriate discount rates.

6. Sum NPV and Financing Effects: Add the base case NPV and the present value of financing
effects to arrive at the APV.

Advanced Considerations

Dynamic Debt Levels

For projects with changing debt levels over time, the present value of tax shields must be calculated
dynamically. This involves projecting the debt levels and corresponding interest tax shields for each
period and discounting them appropriately.

Risk-Adjusted Discount Rates

Different financing effects may warrant different discount rates. For example, while the unlevered
cost of equity is used for the base case NPV, the cost of debt is used to discount tax shields. Riskier
financing effects, such as financial distress costs, may require higher discount rates reflecting their
higher risk.

Conclusion

The Adjusted Present Value (APV) model provides a robust framework for valuing companies and
projects, especially those with significant and complex financing effects. By separating the operating
performance from financing decisions, the APV model offers transparency and flexibility, making it
particularly valuable in leveraged transactions and scenarios with dynamic capital structures.

Despite its complexity and sensitivity to assumptions, the APV model’s ability to explicitly account for
the value impact of financing decisions sets it apart from other valuation methods like the NPV and
WACC. For finance professionals, mastering the APV model is essential for accurately valuing projects
with intricate financing structures and maximizing the strategic use of financial leverage.