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 very 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.
Adjusted Present Value Explanation
The adjusted present value approach is 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. When compared to the more common methods of valuation, the adjusted present value method is newly created.
When valuing your company, it’s important to identify the destroyers in your company.
Adjusted Present Value Formula
The formula for adjusted present value is:
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.
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 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.
These two approaches can get the identical results in theory. 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. Download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.
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