Adjusted Present Value is a business valuation

Business valuation

Business valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business...

 method. APV is the net present value

Net present value

In finance, the net present value or net present worth of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values of the individual cash flows of the same entity...

 of a project if financed solely by ownership equity

Ownership equity

In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...

 plus the present value

Present value

Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...

 of all the benefits of financing. It was first studied by Stewart Myers

Stewart Myers

Stewart Clay Myers is the Robert C. Merton Professor of Financial Economics at the MIT Sloan School of Management. He is notable for his work on capital structure and innovations in capital budgeting and valuation, and has had a "remarkable influence" on both the theory and practice of corporate...

, a professor at the MIT Sloan School of Management

MIT Sloan School of Management

The MIT Sloan School of Management is the business school of the Massachusetts Institute of Technology, in Cambridge, Massachusetts....

 and later theorized by Lorenzo Peccati, professor at the Bocconi University

Bocconi University

Bocconi University is a private university located in central Milan, beside Parco Ravizza. Bocconi provides undergraduate, graduate and post-graduate education, in addition to a range of double degree programs, in the fields of economics, management, finance and law. According to many university...

, in 1973.

The method is to calculate the NPV of the project as if it is all-equity financed (so called base case). Then the base-case NPV is adjusted for the benefits of financing. Usually, the main benefit is a tax shield

Tax shield

A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. For example, because interest on debt is a tax-deductible expense, taking on debt creates a tax shield...

 resulted from tax deductibility of interest payments. Another benefit can be a subsidized borrowing at sub-market rates. The APV method is especially effective when a leveraged buyout

Leveraged buyout

A leveraged buyout occurs when an investor, typically financial sponsor, acquires a controlling interest in a company's equity and where a significant percentage of the purchase price is financed through leverage...

 case is considered since the company is loaded with an extreme amount of debt, so the tax shield is substantial.

Technically, an APV valuation model looks pretty much the same as a standard DCF

Discounted cash flow

In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...

 model. However, instead of WACC

Weighted average cost of capital

The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....

, cash flows would be discounted at the unlevered cost of equity, and tax shield

Tax shield

A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. For example, because interest on debt is a tax-deductible expense, taking on debt creates a tax shield...

s at either the cost of debt(Myers) or following later academics also with the unlevered cost of equity.
. APV and the standard DCF approaches should give the identical result if the capital structure

Capital structure

In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...

 remains stable.

Given data

• Initial investment = 1 000 000
• Expected cashflow to equity = 95 000 in perpetuity
  Perpetuity
  A perpetuity is an annuity that has no end, or a stream of cash payments that continues forever. There are few actual perpetuities in existence...
  
  
• Unlevered cost of equity = 10%
• Cost of debt = 5%
• Actual interest on debt = 5%
• Tax rate = 35%
• Project is financed with 500 000 of debt and 500 000 of equity; this capital structure
  Capital structure
  In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in equity and $80...
  
  is kept in perpetuity

Calculation

• Base-case NPV @10% = –1 000 000 + (95 000/10%) = –50 000 (approx)
• PV of Tax Shield @5% = (0.05 x 500 000 x 0.35)/(0.05) = 175000 (approx)
• APV = –50 000 + 175,000 = 125,000

Note how substantial the effect of tax shield can be. The tax shield, like the cash flow to equity, is perpetual.