Adjusted Present Value Adjusted present value (APV) is a valuation technique that can be used in place of discounted cash

flows using the WACC. The APV approach discounts cash flows at the "opportunity cost of capital" or the required rate of return if the firm is financed with 100% equity. The benefits of interest tax shields due to debt are accounted for in a separate calculation and are added to the all-equity NPV to get the total adjusted present value. Other side effects of financing can be added in an APV calculation. In addition to interest tax shields, we may wish to subtract out the costs of issuing new securities (debt or equity). Estimates could also be made of the likelihood of financial distress costs due to financial leverage which would be discounted to present value. Finally, if special financing arrangements are offered (e.g. low financing rates), these are easily valued in the APV approach. Can the components of APV be captured in a WACC calculation? YES!!! The real advantage here is that financing side effects are separated out and given greater visibility. It is also easier to incorporate changes in capital structure over time using APV than WACC. Debt ratios, subsidies, etc. can materially vary over time leading to recalculations of the WACC in each period (e.g. the equity beta changes). APV does not require recalculations. A final advantage of APV is that different components of the valuation can be discounted at appropriate rates that reflect the risk of each.

APV Example Pro Forma Income Statement EBIT Interest expense EBT Taxes @ .34 Net income Depreciation Capital expenditures NWC delta Other assets delta Pro Forma Balance Sheet Assets Net working capital Net fixed assets Other assets Total assets Liabilities & Equity Revolver @ 7.5% Bank loan @ 8.0% Sub. debt @ 9.5% LT debentures @ 9.0% Total debt Equity Total liabilities + equity Principal repaid 0 60.0 221.0 26.0 307.0

$M

1 22.7 21.6 1.1 0.4 0.7 21.5 10.7 -12.3 -9.0

2 29.8 19.1 10.7 3.6 7.1 13.5 10.1 1.9 -6.9

3 37.1 17.8 19.3 6.6 12.7 11.5 10.4 4.1 -3.4

4 40.1 16.7 23.4 8.0 15.4 12.1 11.5 5.3 0.0

5 42.1 15.8 26.3 8.9 17.4 12.7 13.1 6.1 0.0

1 47.7 210.3 17.0 275.0

2 49.6 206.9 10.1 266.6

3 53.7 205.7 6.7 266.1

4 59.0 205.1 6.7 270.8

5 65.1 205.5 6.7 277.3

13.0 80.0 150.0 0.0 243.0 64.0 307.0 0.0

0.2 60.0 150.0 0.0 210.2 64.7 274.9 32.8

4.8 40.0 150.0 0.0 194.8 71.8 266.6 15.4

11.7 20.0 150.0 0.0 181.7 84.5 266.2 13.1

20.9 0.0 150.0 0.0 170.9 99.9 270.8 10.8

20.0 0.0 0.0 140.0 160.0 117.2 277.2 10.9

Base Cash Flows (no financing effects) EBIT - taxes @ .34 = EBI + depreciation = operating cash flow - additions to NWC - capital expenditures - additions to other assets = free cash flow + terminal value = total free cash flow Present value 244.3 1 22.7 7.7 15.0 21.5 36.5 12.3 -10.7 9.0 47.1 47.1 13.5% 2 29.8 10.1 19.7 13.5 33.2 -1.9 -10.1 6.9 28.1 28.1 discount rate 3 37.1 12.6 24.5 11.5 36.0 -4.1 -10.4 3.4 24.9 24.9 4 40.1 13.6 26.5 12.1 38.6 -5.3 -11.5 0.0 21.8 21.8 5 42.1 14.3 27.8 12.7 40.5 -6.1 -13.1 0.0 21.3 262.9 284.2

Interest Tax Shields Interest tax shield + terminal value = incremental free cash flow Present value 103.7 1 7.344 7.3 9.5% 2 6.5 6.5 3 6.1 6.1 4 5.7 5.7 5 5.372 125.3 130.7

discount rate (reflects risk of tax shield)

APV PV of Base cash flow PV of Interest tax shields APV

244.3 103.7 348.0

13.5% 9.5%

Components of Value Assume: 10 percent improvement in EBIT NWC reductions Asset sales & higher growth 1 2 3 20.4 26.8 33.4 6.9 9.1 11.4 13.5 17.7 22.0 21.5 13.5 11.5 35.0 31.2 33.5 -4.0 -4.0 -4.2 -10.7 -10.1 -10.4 20.3 17.1 18.9 20.3 157.2 13.5% 17.1 18.9

Performance before improvements EBIT - taxes @ .34 = EBI + depreciation = operating cash flow - additions to NWC - capital expenditures = free cash flow + terminal value = baseline free cash flow Present value

4 36.1 12.3 23.8 12.1 35.9 -5.2 -11.5 19.2 19.2

5 37.9 12.9 25.0 12.7 37.7 -6.1 -13.1 18.5 172.7 191.2

Margin improvements Improvement in EBIT - taxes @ .34 = incremental EBI + increment to terminal value = incremental free cash flow Present value 21.4 1 2.3 0.8 1.5 1.5 13.5% 2 3.0 1.0 2.0 2.0 3 3.7 1.3 2.4 2.4 4 4.0 1.4 2.6 2.6 5 4.2 1.4 2.8 25.9 28.7

NWC improvements Incremental cash flow Present value 16.0 1 16.3 13.5% 2 2.1 3 4 5

Asset sales Incremental cash flow Present value 15.6 1 9.0 13.5% 2 6.9 3 3.4 4 5

Higher future growth Incremental terminal value Present value 34.1 1 0.0 13.5% 2 0.0 3 0.0 4 0.0 5 64.3