Adjusted Present Value (APV) Approach
APV =
PV of cash flows from assets +
PV of side effects associated
with the financing (such as
interest tax shield)
• FCF/WACC approach can be difficult to apply
in some settings
• APV is no more difficult to use than
FCF/WACC
• Theoretically the 2 approaches will produce
the same firm value
Example: APV vs. FCF/WACC
1. Debt in capital structure
2. EBIT
3. Interest
4. Profit before tax
5. Tax
6. Profit after tax
7. Dividends
8. Total pmts to security holders (3+7)
9. Cost of debt
10. Cost of equity
11. Market value of debt (3/9)
12. Market value of equity (7/10)
13. Market value of firm (11+12)
14. Book value of debt
15. Book value of equity
16. Book value of firm
17. Book value debt ratio (14/16)
18. Market value debt ratio (11/13)
19. WACC
20. FCF
21. Market value of firm (20/19)
0%
10%
$120,000 $120,000
0
4,125
120,000 115,875
60,000
57,938
60,000
57,938
60,000
57,938
60,000
62,063
8.25%
12.50%
0
50,000
500,000 463,500
500,000 513,500
0
500,000
500,000
0.0%
0.0%
12.0%
$60,000
$500,000
50,000
450,000
500,000
10.0%
9.7%
11.7%
$60,000
$513,500
APV procedure
1. Calculate value of the firm assuming it
is all equity financed (i.e. no interest
expense)
Discount rate uses CAPM and asset
(unlevered) beta
2. Calculate the value of tax shields
(based on the difference in tax
payments vs. the unlevered case in
step 1).
APV Example
Assume:
Asset beta = 0.7
Long Term Treasury = 6%
Market Premium = 7.8%
From CAPM, Discount rate = .06 + .7*.078 = .1146
Also assume: Terminal value = (approx.) 7 x FCF
Step 1:
Year:
EBIT
Tax @ 40%
Capex
Depreciation
Increase in NWC
FCF
Terminal Value
1
100
40
30
20
20
30
2
108
43
32
22
22
33
3
116
46
35
24
23
36
4
124
50
37
26
25
38
5
134
53
40
28
27
41
287
PV@11.46
27
26
26
25
24
167
Total PV
295
APV example (continued)
Step 2: Calculate value of tax shield.
Assume $150 of debt at 8% (pretax) initially outstanding & is
repaid from available cash flow
Year:
EBIT
Interest (=outstanding debt*.08)
Profit before tax
Tax
Profit after tax
Capex
Depreciation
Increase in NWC
Cash flow available to pay down debt
Ending Debt =
(beginning debt – pay down)
1
100
12
88
35
53
30
20
20
23
2
108
10
98
39
59
32
22
22
27
3
116
8
108
43
65
35
24
23
31
4
5
124 134
6
3
118 131
47 52
71 79
37 40
26 28
25 27
35 40
127
101
70
35
0
APV Example (step 2 continued)
Compare tax payments with vs. without debt. The
difference equals the tax savings available from
the interest deduction (tax shield).
Discount tax savings at pre-tax rate of return on
debt*
Tax payments with no debt
Tax payments with debt @ 8%
Tax savings
40
35
5
PV of tax savings @ 8%
$13
43
39
4
46
43
3
* assumes risk of tax shields being realized = risk of debt
50
47
3
53
52
1
APV example: non-interest tax shields
Suppose in addition there is a tax loss carryforward of
$100 million. This means that the first $40 million of
taxes need not be paid.
Year
Tax savings Taxable Income
Used
1
35
87.5
2
5
100
PV of tax savings @ 8%
$37
Present value these savings at 8%, produces a value of 37
for the tax loss carryforward.
Conclusion: Total firm value =
value of all equity firm (295) +
side effects of financing (13 + 37) = 345.
RJR Nabisco buyout
RJR Nabisco buyout