MERGERS AND ACQUISITION REVIEWER

 The value of an unlevered firm’s operations is the present value of the firm’s free cash flows discounted at the
unlevered cost of equity, and the value of the tax shield is the present value of all of the interest tax savings (TS),
discounted at the unlevered cost of equity, rsU:10

APV APPROACH

1. Calculate the target’s unlevered cost of equity, rsU, based upon its current capital structure at the time of the
acquisition

2. Project the free cash flows, FCFt, and the annual interest tax savings, TSt. The tax savings are equal to the
projected interest payments multiplied by the tax rate

3. Calculate the horizon value of an unlevered firm at Year N (HVU,N), which is the value of all free cash flows
beyond the horizon discounted back to the horizon at the unlevered cost of equity. Also calculate the horizon
value of the tax shield at Year N (HVTS,N), which is the value of all tax shields beyond the horizon discounted back
to the horizon at the unlevered cost of equity. Because FCF and TS are growing at a constant rate of g in the
post-horizon period, we can use the constant growth formula:
4. Calculate the present value ofthefreecashflowsandtheir horizonvalue.Thisisthe value of operations for the
unlevered firm—that is, the value it would have if it had no debt. Also calculate the present value of the yearly
tax savings during the forecast period and the horizon value of tax savings. This is the value that the interest tax
shield contributes to the firm. The sum of the value of unlevered operation and the value of the tax shield is
equal to the value of operations for the levered firm:

5. To find the total value of the firm, add the value of operations to the value of any nonoperating assets, such as
marketable securities. To find the value of equity, subtract the value of the debt before the merger from the
total value of the firm.
 THE FREE CASH FLOW TO EQUITY (FCFE) APPROACH
(FCFE) is the cash flow available for distribution to common shareholders, it should be discounted. And also called as
equity residual model, discounts the projected FCFEs at the cost of equity to determine the value of the equity from
operations.