Adjusted Present Value - Definition
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Adjusted Present Value Definition
Adjusted Present Value refers to the sum of net present value of an organization or a project that is totally based on equity financing and present value of financing advantages, if any. These financial benefits, when considered, provide tax cushions (for example: deductible interest) to adjusted present value. APV Formula = Unlevered Firm Value + Net Debt Effect
A Little More on What is Adjusted Present Value
Net effect of debt consists of the following factors:
- Interest tax shield which is formed for companies in debt as the interest on debt is considered to be tax-deductible. It is ascertained by multiplying interest expense with rate of tax provided. It involves the interest tax shield only for that specific year.
- The next thing to consider is the present value of interest tax shield. The present value of interest tax shield is calculated as follows:
(tax rate * debt load * interest rate) / interest rate
Calculation of Adjusted Present Value - APV
For ascertaining the Adjusted Present Value,
- Ascertain the worth of unlevered organization
- Then compute net value of debt financing
- Add the value of unlevered organization calculated in step 1 and net value of debt financing calculated in step 2
The adjusted present value tells an investor about the advantages of tax shields occurring from at least one tax deductions of interest expenses or a subsidized loan set at rates below market rates. APV appears to be more reliable and preferable for carrying out leveraged buyout transactions. Because of the cost of capital declining with more utilization of leverage, the worth of a project financed on debt is more than the one financed on equity. Debt, if properly used, can convert any project with a negative net present value to a positive one. NPV considers cost of equity as the discount rate, while in case of APV, weighted average cost of capital is considered as discount rate.
Example of How to Use Adjusted Present Value APV
For arriving at the adjusted present value, the total of present value of interest tax shield is included at the time of making financial estimates. For instance, the present value of a companys free cash flow and its terminal value is $100,000. The interest rate is 7% and tax rate is 30%. The debt load is of $50,000 and it carries an interest tax shield of $15,000 ($50,000 * 30% * 7%) / 7%). Therefore, APV will be $115,000, that is the sum of FCF and terminal value and interest tax shield ($100,000 + $15,000).
APV vs Discounted Cash Flow
Though there is not much difference between adjusted present value and discounted cash flow, adjusted present cash flow does not include taxes or any other financing impacts in a weighted average cost of capital (WACC). While WACC is applied in discounted cash flow, the adjusted present value measures the effects of cost of debt and cost of equity in an independent manner. The adjusted present value is less significant as compared to discounted cash flow method.
Drawbacks of using Adjusted Present Value
Generally, the adjusted present value is less frequently used as discounted cash flow method. It can consist of more calculations, but the valuation is more appropriate and clearer in nature.
References for Adjusted Present Value APV
https://strategiccfo.com/adjusted-present-value-apv/https://www.investopedia.com Investing Financial Analysishttps://corporatefinanceinstitute.com Resources Knowledge Valuationhttps://strategiccfo.com/adjusted-present-value-apv/https://en.wikipedia.org/wiki/Adjusted_present_value
Academics research on Adjusted Present Value APV
Luehrman, T. A. (1997). Using APV (adjusted present value): a better tool for valuing operations. Harvard business review, 75(3), 145-6. Anyone who learned valuation techniques more than a few years ago is probably due for a refresher course. For the past 25 years, managers have been taught that the best practice for valuing assets-that is, an existing business, factory, product line, or market position-is to use a discounted-cash-flow (DCF) methodology. That is still true. But the particular version of DCF that has been accepted as the standard-using the weighted-average cost of capital (WACC)-is now obsolete. Today's better alternative, adjusted present value (APV), is especially versatile and reliable. It will likely replace WACC as the DCF methodology of choice among generalists. Like WACC, APV is used to value operations, or assets-in-place-that is, any existing asset that will generate a stream of future cash flows. Timothy Luehrman explains APV and walks readers through a case example designed to teach them how to use it. He argues that APV always works when WACC does-and sometimes when WACC doesn't, because it requires fewer restrictive assumptions. And APV is less prone to yield serious errors than WACC is. But, most important, general managers will find that APV's power lies in the managerially relevant information it provides. APV can help managers analyze not only how much an asset is worth but also where the value comes from. Finding value where none exists: pitfalls in using adjusted present value, Booth, L. (2002). Finding value where none exists: pitfalls in using adjusted present value. Journal of Applied Corporate Finance, 15(1), 95-104. There are several conceptually correct methods for valuing firms and projects, including the weighted average cost of capital (WACC) approach, the flows to equity (FTE) method, and the adjusted present value (APV) or valuationbycomponents method. The author examines the relative advantages of these frameworks and offers guidance as to when they are likely to be most useful. The key message is a caution to wouldbe users of APV: it is frequently unreliable and should be used only in conjunction with more conventional valuation frameworks. It works best in transactions that involve structured financings, such as leveraged buyouts and project and real estate financings. Even in these cases, however, its usefulness depends on theoretical concepts that in practical applications have a wide margin of error. In general, WACC is a robust and appropriate valuation framework as long as the firm has a target debt ratio. The FTE method is most relevant for acquisitions and very large projects. The author shows how APV and FTE can be formulated to be consistent with the WACC valuation. The issue, however, is not whether the techniques can be made consistent through relatively complex adjustments by sophisticated users, but rather what happens when they are used in everyday applications by practitioners unfamiliar with the somewhat arcane valuation issues involved. Riskadjusted discount ratesextensions from the averagerisk case, Harris, R. S., & Pringle, J. J. (1985). Riskadjusted discount ratesextensions from the averagerisk case. Journal of Financial Research, 8(3), 237-244. This paper provides an approach for developing riskadjusted discount rates that follows naturally from the standard presentation of the weighted average cost of capital. In addition to examining the implied assumptions about the valuation of corporate debt, the paper shows the pedagogic advantages of the proposed approach. Tax-adjusted discount rates, Sick, G. A. (1990). Tax-adjusted discount rates. Management Science, 36(12), 1432-1450. This paper develops models for discount rates that are adjusted for the interest tax shields of an infra-marginal firm in a general tax equilibrium where there is cross-sectional variation in corporate tax rates. Under the assumption that the firm optimally maintains a predetermined debt ratio, a tax-adjusted riskless discount rate model is given for valuing certainty-equivalents and a tax-and-risk-adjusted discount rate model is given for valuing expected cash flows. For the latter case, the asset, equity, debt and tax-shield betas are derived and a weighted average cost of capital interpretation is given. The tax-adjusted CAPM/APT security market lines for expected returns in stock and bond markets both have the same slope but different intercepts. A formula is also provided for the present value of the interest tax shield when the firm optimally maintains a predetermined debt level. The analysis here also differs from the existing literature in the following respects: It allows for cross-sectional variation in corporate tax rates and personal tax rates. It shows that the market values of risky and riskless interest tax shields differ only to the extent that tax laws provide for nonlinear taxation of gains and losses. It also shows that interest tax shields should be discounted at a tax-adjusted discount rate that reflects the fact that they accrue to equity investors, rather than debt investors. Continuous-time simplifications of the formulas in this paper and the previous literature are also given. Corporate debt management and the value of the firm, Lewellen, W. G., & Emery, D. R. (1986). Corporate debt management and the value of the firm. Journal of Financial and Quantitative Analysis, 21(4), 415-426. Three alternative characterizations of corporate debt management policy, which have had wide currency in the literature, are examined. They are shown to give rise to substantial differences in their predictions of total-firm value. This study concludes that, of the three, the one that assumes that management periodically rebalances the firm's debt levels in response to evolving new information on expected future operating cash flows is the most logically consistent. On that basis, a reinterpretation of the available empirical evidence on the tax effect of debt is indicated.