Question

Please describe the method for evaluating the investment using Adjusted Present Value, and list the data you would need to determine whether to accept or reject the project from the company perspective.

Answer 1

Adjusted Present Value (APV)

Adjusted Present Value (APV) is used for the valuation of projects and companies. It takes the net present value (NPV), plus the present value of debt financing costs, which include interest tax shields, costs of debt issuance, costs of financial distress, financial subsidies, etc.

So why do we use Adjusted Present Value instead of NPV in evaluating projects with debt financing? To answer this, we first need to understand how financing decisions (debt vs. equity) affect the value of a project.

The value of a project financed with debt may be higher than that of an all equity-financed project since the cost of capital often decreases with leverage, turning some negative NPV projects into positive ones. Thus, under the NPV rule, a project may be rejected if it is financed with only equity but may be accepted if it is financed with some debt.

The Adjusted Present Value approach takes into consideration the benefits of raising debts (e.g. interest tax shield), which NPV does not do. As such, APV analysis can be preferred in highly leveraged transactions.

Adjusted Present Value assumptions

We make the following simplifying assumptions before using the APV approach in the valuation of a project:

1. The project’s risk is equal to the average risks of other projects within the firm, which is also the risk of the firm. In other words, the project in question is a “typical” project that the firm usually takes on. In this case, the relevant discount rate for the project is based on the risk of the firm.
2. Corporate taxes are the only important market imperfection at the level of debt chosen. This means that we focus only on the interest tax shields and ignore the effects generated by the costs of debt issuance and financial distress.
3. All debt is perpetual.

The Adjusted Present Value for valuation

The APV method to calculate the levered value (VL) of a firm or project consists of three steps:

Step 1

Calculate the value of the unlevered firm or project (VU), i.e. its value with all-equity financing. To do this, discount the stream of FCFs by the unlevered cost of capital (rU).

Step 2

Calculate the net value of the debt financing (PVF), which is the sum of various effects, including:

•       PV(Interest tax shields) – our main focus
•       PV(Issuance costs)
•       PV(Financial distress costs)
•       PV(Other market imperfections)

Step 3

Sum up the value of the unlevered project and the net value of debt financing to find the adjusted present value of the project. That is, VL = VU + PVF.