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Adjusted Present Value (APV) Method of Valuation

See Also:
Valuation Methods
Net Present Value Method
Internal Rate of Return Method
NPV vs IRR
Capitalization

Adjusted Present Value (APV) Method of Valuation Definition

Adjusted Present Value (APV) Method of Valuation is the net present value of a project if financed solely by equity (present value of un-leveraged cash flows) plus the present value of all the benefits of financing. Use this method for a highly leveraged project.

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Adjusted Present Value Method Calculation

1. Calculate the value of un-leveraged project by discounting the expected free cash flow to the firm at the un-leveraged cost of equity.

2. Then, calculate the expected tax benefit from a given level of debt by discounting the expected tax saving at the cost of debt to reflect the riskiness of this cash flow.

3. Finally, evaluate the effect of a given level of debt on the default risk of a company and expected bankruptcy costs.

Thus, the APV calculation is as follows:

Value of the operating assets = Un-levered firm value + PV of tax benefits – Expected Bankruptcy Costs

Adjusted present value = value of the operating assets + value of cash and marketable securities.

Adjusted Present Value Application

APV method is very similar to traditional discounted cash flow (DCF) model. However, instead of weighted average cost of capital(WACC), cash flows would be discounted at the cost of assets, and tax shields at the cost of debt. Technically, an APV valuation model combined impact of both growth and the tax shield of debt on the cost of capital, the cost of equity, and systematic risk. Thus it is a more flexible way of approaching valuation than other method. However, APV method has some flaws. Company value will be overstated when adding the tax benefits to un-levered company value to get the levered company value, especially for some companies with high debt ratios.

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Adjusted Present Value (APV) Method of Valuation

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Adjusted Present Value (APV) Method of Valuation

 

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NPV vs IRR

See also:
Net Present Value Method
NPV Versus Payback Method
Internal Rate of Return Method
Capital Budgeting Methods
Discount Rate
Weighted Average Cost of Capital
Discounted Cash Flow versus Internal Rate of Return (dcf vs irr)

NPV vs IRR

Key differences between the most popular methods, NPV vs IRR (the Net Present Value Method and Internal Rate of Return Method), include the following:

NPV Method

Calculate NPV in terms of currency. Then express IRR in terms of the percentage return a firm expects the capital project to return. Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not.

IRR Method

The IRR Method cannot be used to evaluate projects where there are changing cash flows For example, an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm. However, the IRR Method does have one significant advantage. Managers tend to better understand the concept of returns stated in percentages. They find it easy to compare to the required cost of capital.

NPV vs IRR Comparison

While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows. This is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.


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Other Variations of NPV vs IRR

Adjusted Present Value (APV)

The Adjusted Present Value (APV) Method is a flexible DCF method that takes into account interest related tax shields. Furthermore, it is designed for firms with active debt and a consistent market value leverage ratio.

Profitability Index (PI)

The Profitability Index (PI) Method, which is modeled after the NPV Method, is measured as the total present value of future net cash inflows divided by the initial investment. This method tends to favor smaller projects. Therefore, it is best used by firms with limited resources and high costs of capital.

Bailout Payback Method

The Bailout Payback Method is a variation of the Payback Method. Furthermore, it includes the salvage value of any equipment purchased in its calculations.

Real Options Approach

The Real Options Approach allows for flexibility and encourages constant reassessment based on the riskiness of the project’s cash flows. It is also based on the concept of creating a list of value-maximizing options to choose projects from. In fact, management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary. It is also noteworthy that there is not a lot of support for this method among financial managers at this time.

Both IRR and NPV are rates which assign value to your company. If you’re looking to sell your company, then download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

ROCE

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NPV vs IRR

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Discount Rate

See Also:
EBITDA Definition
Cost of Capital Funding
Arbitrage Pricing Theory
Capital Budgeting Methods
Required Rate of Return

Discount Rate Definition

The discount rate definition, also known as hurdle rate, is a general term for any rate used in finding the present value of a future cash flow. In a discounted cash flow (DCF) model, estimate company value by discounting projected future cash flows at an interest rate. This interest rate is the discount rate which reflects the perceived riskiness of the cash flows.


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Discount Rate Explanation

Using discount rate, explained as the risk factor for a given investment, has many benefits. The purpose is to account for the loss of economic efficiency of an investor due to risk. Investors use this rate because it provides a way to account and compensate for their risk when choosing an investment. Furthermore, this provides, with each choice, a buffer to provide for the chance of failure in an investment over time as well as many investments over a portfolio. Though risk is somewhat of a sunk cost, still include it to add a real-world element to financial calculations. It is a measure used to prevent one from becoming “calculator rich” without actually increasing personal wealth.

In DCF model, there are two methods to get discount rate: weighted average cost of capital (WACC) and adjusted present value (APV). For WACC, calculate discount rate for leveraged equity using the capital asset pricing model (CAPM). Whereas for APV, all equity firms calculate the discount rate, present value, and all else.

The Discount Rate should be consistent with the cash flow being discounted. For cash flow to equity, use the cost of equity. For cash flow to firm, use the cost of capital.

Discount Rate Formula

A succinct Discount Rate formula does not exist; however, it is included in the discounted cash flow analysis and is the result of studying the riskiness of the given type of investment. The two following formulas provide a discount rate:

First, there is the following Weighted Average Cost of Capital formula.

Weighted Average Cost of Capital (WACC) = E/V * Ce + D/V * Cd * (1-T)

Where:
E = Value of equity
D = Value of debt
Ce = Cost of equity
Cd = Cost of debt
V = D + E
T = Tax rate

Then, there is the following Adjusted Present Value formula.

Adjusted Present Value = NPV + PV of the impact of financing

Where:
NPV = Net Present Value
PV = Present Value

Calculation

See the following calculation of WACC and APV.

For WACC:

WACC = $10,000/$20,000 * $2,000 + $10,000/$20,000 * $1,000 * (1-.3) = $1,050,000

If:
E = $10,000
D = $10,000
Ce = $2,000
Cd = $1,000
V = $20,000
T = 30%

For APV:

APV = $1,000,000 + $50,000 = $1,050,000

If:
NPV = $1,000,000
PV of the impact of financing = $50,000

Discount Rate Example

For example, Donna is an analyst for an entrepreneur. Where her boss is the visionary, Donna performs the calculations necessary to find whether a new venture is a good decision or not. She does not need a discount rate calculator because she has the skills to provide value above and beyond this. Donna is the right hand woman to the entrepreneur which she aspires to be. But she first needs to prove herself in the professional world.

Donna’s boss wants to know how much risk he has taken on his last venture. He would like, eventually, to find the discount rate business valuation to judge levels for performance and new ventures alike.

Donna’s boss gives Donna the financial information she needs for one venture. She finds the discount rate (risk) using the following equation:

WACC = $10,000/$20,000 * $2,000 + $10,000/$20,000 * $1,000 * (1-.3) = $1,050,000

If:
E = $10,000
D = $10,000
Ce = $2,000
Cd = $1,000
V = $20,000
T = 30%

Next, Donna’s boss has her find the discount rate for another venture that he is involved in. The results are below:

Adjusted Present Value = NPV + PV of the impact of financing

Where:
NPV = Net Present Value
PV = Present Value

Donna appreciates her experience with her employer. As a result, she is sure that with this experience she can find the path to mentor another just like her.

Discount Rate Definition, Discount Rate Formula, Discount Rate Example, discount rate

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Adjusted Present Value Example

See Also:
Adjusted Present Value (APV)

Adjusted Present Value Example

Joey owns a small chemical plant called Chemco. Chemco, despite the effects of the recent recession, is doing fine. They are 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.

Adjusted Present Value Calculation

The analyst performs this calculation based on the Chemicalventures financials:

If…

Investment = $500,000

Cash flow 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.

Then…

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

Joey is pleased to find these results because they have saved him from making a poor business decision. He contacts Billy to tell him that, unfortunately, Chemco can not purchase Chemicalventures.

adjusted present value example

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Adjusted Present Value (APV)

See Also:
Adjusted Present Value Example
Cost of Capital Funding
Arbitrage Pricing Theory
Capital Asset Pricing Model
Capital Budgeting Methods
Required Rate of Return

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. 

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Adjusted Present Value Formula

The formula for adjusted present value is:

NPV (of a venture financed solely with equity capital) + PV of financing

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.

If:
Investment = $500,000
Cash flow from equity = $25,000
Cost of equity = 20%
Cost of Debt = 7%
Interest on debt = 7%
Tax = 35%
Finance the deal 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, obtain the value of a levered firm 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.

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.

adjusted present value

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