What Does Adjusted Present Value Mean?

An Adjusted Present Value (APV) valuation is very similar to DCF valuations, however there are several differences between the methodologies.

The APV is the net present value of a firm that is financed solely by equity, plus the present value of financing benefits.

APV = Unlevered NPV Cash Flows (Including Terminal Value) + NPV of Financing Side Effects (ex: Interest Rate Tax Shields)

 

Basically you value your FCF at unlevered cost of capital to get the value of the unlevered firm and then adding the value from having leverage (interest tax shields) given the amount of debt each period. With WACC, you're assuming a constant capital structure throughout...

 

As Warren Buffet once said, "If you can eliminate the federal government as a 34% partner in your business, it's got to be worth more!"

Modigliani-Miller Theorem states that the value of the Levered Firm is equal to the Value of the Unlevered Firm plus the tax rate multiplied by the level of debt (AKA the PV of the Tax Shield).

For one, you have to assume the same level of assets in both scenarios to compare. Lets also assume that book value = market value and a 20% federal tax rate. So in your example above assume that the firm has $2,000 in assets. Scenario 1 is that the firm finances these assets with 100% stock. Scenario 2 lets assume 50% stock 50% debt. The value of the unlevered firm would be $2,000 and the value of the levered firm would be $2,000 plus (20%*$1,000 or $200). The "Tax Shield is the Tax Rate multiplied by the level of debt and is a value to the Equity Holders.

Unlevered Firm = $2,000 Equity Levered Firm = $1,200 Equity + 1,000 Debt

If you want more info PM me.

 

On (2) For APV you should use the same FCF as you would use for your regular DCF with WACC. The difference is that you will discount the FCF with the cost of unlevered equity (and not WACC) and that afterwards you add the effect of financing to arrive at the EV (except if you have weird stuff, it will only be discounting the interest tax shields that you calculate on the side, discounting them at the cost of debt)

 

Update:

I just tried a backtest of the formula and it failed miserably. I am wondering if there is a better formula I should be using or if I should make some sort of adjustment to the formula.

 

Are you discounting the future cash flows? If so, what rate are you using?

As an FYI, what you're getting is an enterprise value, not an equity value. So you're going to have to add cash and subtract debt to get to equity value. If you want to find equity value using the FCF method, you'll have to back out net interest expense from EBIT before multiplying by (1-t).

Your formula is correct. May want to add back stock-based compensation and other non-cash (amortization) expenses.

 

Since I'm using APV, I discount FCF by the CAPM cost of equity. I discount the interest tax shield by the cost of debt.

For the cost of equity, I use the 10 year treasury + beta times the 10 year market risk premium, as I plan on investing for a longer term. For the cost of debt, I use the 10 year bond for the company I am valuing. If no such bond exists, I use corporate bond spreads.

 

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