Adjusted Present Value (APV) Approach

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 0% 10%
2. EBIT $120,000 $120,000
3. Interest 0 4,125
4. Profit before tax 120,000 115,875
5. Tax 60,000 57,938
6. Profit after tax 60,000 57,938
7. Dividends 60,000 57,938
8. Total pmts to security holders (3+7) 60,000 62,063
9. Cost of debt 8.25%
10. Cost of equity
12.50%
11. Market value of debt (3/9) 0 50,000
12. Market value of equity (7/10) 500,000 463,500
13. Market value of firm (11+12) 500,000 513,500
14. Book value of debt 0 50,000
15. Book value of equity 500,000 450,000
16. Book value of firm 500,000 500,000
17. Book value debt ratio (14/16) 0.0% 10.0%
18. Market value debt ratio (11/13) 0.0% 9.7%
19. WACC 12.0% 11.7%
20. FCF $60,000 $60,000
21. Market value of firm (20/19) $500,000 $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: 1 2 3 4 5
EBIT 100 108 116 124 134
Tax @ 40% 40 43 46 50 53
Capex 30 32 35 37 40
Depreciation 20 22 24 26 28
Increase in NWC 20 22 23 25 27
FCF 30 33 36 38 41
Terminal Value 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: 1 2 3 4 5
EBIT 100 108 116 124 134
Interest (=outstanding debt*.08) 12 10 8 6 3
Profit before tax 88 98 108 118 131
Tax 35 39 43 47 52
Profit after tax 53 59 65 71 79
Capex 30 32 35 37 40
Depreciation 20 22 24 26 28
Increase in NWC 20 22 23 25 27
Cash flow available to pay down debt 23 27 31 35 40
Ending Debt =
(beginning debt – pay down) 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 40 43 46 50 53
Tax payments with debt @ 8% 35 39 43 47 52
Tax savings 5 4 3 3 1
PV of tax savings @ 8% $13
* assumes risk of tax shields being realized = risk of debt

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