Adjusted Present Value

4 Key excerpts on "Adjusted Present Value"

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  eBook - ePub

  Investment Valuation

  Tools and Techniques for Determining the Value of any Asset, University Edition

  • Aswath Damodaran(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  In the cost of capital approach, the effects of leverage show up in the cost of capital, with the tax benefit incorporated in the after-tax cost of debt and the bankruptcy costs in both the levered beta and the pretax cost of debt. Will the two approaches yield the same value? Not necessarily. The first reason for differences is that the models consider bankruptcy costs very differently, with the Adjusted Present Value approach providing more flexibility in allowing you to consider indirect bankruptcy costs. To the extent that these costs do not show up or show up inadequately in the pretax cost of debt, the APV approach will yield a more conservative estimate of value. The second reason is that the APV approach considers the tax benefit from a dollar debt value, usually based on existing debt. The cost of capital approach estimates the tax benefit from a debt ratio that may require the firm to borrow increasing amounts in the future. For instance, assuming a market debt-to-capital ratio of 30percent in perpetuity for a growing firm will require it to borrow more in the future, and the tax benefit from expected future borrowings is incorporated into value today. Generally speaking, the cost-of-capital approach is a more practical choice when valuing ongoing firms that are not going through contortions on financial leverage; it is easier to work with a debt ratio than with dollar-debt levels. The APV approach is more useful for transactions that are funded disproportionately with debt and where debt repayment schedules are negotiated or known; this is why it has acquired a footing in leveraged-buyout circles. Finally, there is a subtle distinction in how the tax benefits from debt are incorporated in value in the two approaches. While the conventional APV approach uses the pre-tax cost of debt as the discount rate to estimate the value of the tax savings from debt, there are variations on the APV that discount the tax savings back at the cost of capital or the unlevered cost of equity that yield values that are closer to those obtained in the cost of capital approach.

  APV WITHOUT BANKRUPTCY COSTS

  There are many who believe that Adjusted Present Value is a more flexible way of approaching valuation than traditional discounted cash flow models. This may be true in a generic sense, but APV valuation in practice has significant flaws. The first and most important is that most practitioners who use the Adjusted Present Value model ignore expected bankruptcy costs. Adding the tax benefits to unlevered firm value to get to levered firm value makes debt seem like an unmixed blessing. Firm value will be overstated, especially at very high debt ratios, where the cost of bankruptcy is clearly not zero.

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  eBook - ePub

  Mergers, Acquisitions, and Other Restructuring Activities

  An Integrated Approach to Process, Tools, Cases, and Solutions

  • Donald DePamphilis(Author)
  • 2011(Publication Date)
  • Academic Press

    (Publisher)

  50

  The primary advantage of the APV method is its relative computational simplicity. Although somewhat more complex, the cost of capital method attempts to adjust for the changing level of risk over time, as the LBO reduces its leverage over time. Thus, the CC method takes into account what is actually happening in practice.51 Table 13.10 summarizes the process steps as well as the strengths and weaknesses of the cost of capital and Adjusted Present Value methods.

  Table 13.10. Comparative LBO Valuation Methodologies

  Process Steps	Cost of Capital Method	Adjusted Present Value Method
  Step 1	Project annual cash flows, including all financing considerations and tax savings, until anticipate exiting the business	Project annual cash flows to equity investors and interest tax savings
  Step 2	Project annual debt-to-equity ratios	Value target, including terminal value but without tax savings
  Step 3	Calculate terminal value	Estimate PV of tax savings
  Step 4	Adjust discount rate to reflect declining cost of equity as debt is repaid	Add PV of firm without debt, including terminal period and PV of tax savings
  Step 5	Determine if NPV of projected cash flows ≥ 0	Determine if NPV of projected cash flows ≥ 0
  Advantages	• Adjusts discount rate to reflect diminishing risk	• Simplicity
  Disadvantages	• Calculations more tedious than alternative methods	• Ignores effects of leverage on discount rate as debt repaid • To incorporate effects of leverage, requires estimation of cost of and probability of financial distress for highly leveraged firms

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  Strategic Finance for Criminal Justice Organizations

  • Daniel Adrian Doss, William H. Sumrall III, Don W. Jones(Authors)
  • 2017(Publication Date)
  • Routledge

    (Publisher)

  Some initiatives may require periods that are longer than those that are considered within this text. When these situations occur, it is recommended that NPV calculations be performed through the use of software spreadsheets, proprietary software, or financial calculators. Also, within the context of collegiate finance courses, a tabular solution is also available to solve NPV problems involving a variety of periods. However, for the purposes of this text, the use of the basic formula is appropriate to demonstrate the basic concept of net present value and to delineate the calculations through which NPV problems are solved. Future editions of this text, if any, are anticipated to contain the tabular solution methods of NPV problems.

  6.8 Chapter Comments and Summary

  This chapter introduced the net present value (NPV) method of capital budgeting. The methods of capital budgeting encompass perspectives of time, cash value, rate, and profitability potential. The NPV is indicative of a cash perspective regarding the rendering of capital budgeting decisions. Further, the NPV method incorporates the time value of money within its primary construct. Derivation of the NPV method can occur through algebraic manipulation of the current monetary value formula given in Chapter 4 .

  The NPV method involves a consideration of the anticipated cash flows of a capital investment through time. These anticipated future values are discounted to determine their current monetary equivalencies. Conceptually, the NPV is the sum of the present monetary value of the anticipated future cash flows of a potential capital investment excluding the costs of investment. Therefore, the NPV method provides a cash-based perspective regarding capital budgeting initiatives. The NPV may be used as a solitary method of capital budgeting or may be used in conjunction with any (or all) of the capital budgeting methods described within this text. The NPV method may be used to examine single capital initiatives or multiple capital initiatives. Further, this method may be used with or without the constraints imposed by mutual exclusion conditions.

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  Litigation Services Handbook

  The Role of the Financial Expert

  • Roman L. Weil, Daniel G. Lentz, Elizabeth A. Evans(Authors)
  • 2017(Publication Date)
  • Wiley

    (Publisher)

  The income approach has become the most widely used valuation approach because practitioners can use it even when the company has no comparable businesses or transaction data. The approach is rooted in valuation theory, which holds that the value of an asset equals the present value of its expected future returns. The income approach includes the discounted cash flow (DCF) method and two derivatives of the DCF method: the capitalization of earnings method and the Adjusted Present Value (APV) method.

  Appraisal literature uses the term income approach, but the literature does not use income in the same manner as accountants do. The valuation literature broadly uses the term to mean some form of economic benefits derived from owning an asset. Notwithstanding differences in definitions of income, this approach uses several types of economic benefit streams, such as the firm’s net income as defined in accounting literature, or cash flow, or income on a debt-free basis. However, analysts most frequently use cash flow as the measure of economic benefits from owning a business, because published cost of capital data usually relates to rates of returns based on cash flows. Cost of capital data on net income is not commonly available.

  In theory, the resulting value of an asset should be identical whether one uses the firm’s cash flow or income if the analyst properly matches the discount rate to the economic benefit stream. However, timing differences in cash flow items would cause the values to differ when using a DCF or APV model.

  Analysts can use different cash flow measurements while employing the DCF method. Some analysts use free cash flow to the firm (FCFF), whereas others use free cash flow to equity holders (FCFE). Use of either FCFF or FCFE often depends on whether the analyst needs to value the entire firm or solely the equity or a portion of the equity. Some practitioners prefer the term net cash flow

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