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What is APV?
The APV approach to DCF valuation determines value by adding the net present value of a project as if it were financed solely by equity plus the present value of any financing costs or benefits (the additional effects of debt)
In other words, the financing effects of debt such as the various tax shields provided by the deductibility of interest and the benefits of other investment tax credits are calculated separately. APV is often used for highly leveraged transactions such as LBOs
The WACC approach to DCF valuation determines value by adjusting the cost of capital to reflect the capital structure (and therefore financial enhancements), APV analyzes financial maneuvers separately and then adds their value to that of the business
APV unbundles WACC i.e. unbundles components of value and treats each one separately In contrast, WACC assumes debt is rebalanced and bundles all financing side effects into the discount rate
In other words, the WACC approach involves discounting unlevered (i.e. pre-interest, but after-tax) cash flows at a rate that reflects a blend of the costs of the different sources of financing
Value of all financing side effects Base-case value APV = Value of the project as if it were financed entirely with equity Interest rate tax shields
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Discount the tax shield to NPV using the cost of debt (fixed debt assumption) Discount the tax shield to NPV using the zero-levered WACC, I.e. the unlevered cost of equity (rebalanced debt assumption)
Assess the probability of bankruptcy Estimate the costs of bankruptcy Calculate the costs of financial distress by multiplying the costs of bankruptcy by the probability of going bankrupt
Issuance costs
Raising equity often involves issues costs such as the issue discounts, commissions, fees and underwriting costs Although such costs are disregarded when using APV for firm valuations, there are often taken into account when APV is used to evaluate separate projects
APV Example #1
Project A has an NPV of $150,000. The Company has to issue stock, with brokerage costs of $200,000, in order to finance the project Project NPV Stock Issue Cost Adjusted NPV = $150,000 -$200,000 -$ 50,000
APV Example #2
Project B has an NPV of -$20,000. The Company has to issue $2,314,285 of debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000. The adjusted NPV of the project would then be calculated as follows: Project NPV -$20,000 Debt Issue Cost $60,000 Adjusted NPV = $40,000
Assuming a net reinvestment rate of 54.34%: Step 2: Estimate the cost of equity
If Tubes beta is 1.17, the risk free rate is 10.5% and the risk premium is 9.23%, then:
Cost of equity = 10.5% + 1.17(9.23%) = 21.30%
Step 3: Estimate the WACC Assume cost of debt for Tube Corp. is 12.0%, and that the market value of equity is $2,282.0 million and the market value of debt is $1,807.3 million, then: WACC = (Cost of equity) ((E/(D+E)) + (After tax Cost of Debt)((D/D+E)) = (21.3%)(0.5581) = (12.0%)(1-0.30)(0.4419) = 15.6% WACC Valuation = Value of the operating assets + Value of cash and marketable securities = [($212.2)/(0.156 - .05)] + $1,365.3 = $3,367.3 million
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Unlevered Beta =
If the risk free rate is 10.50% and there is a risk premium of 9.23%, then unlevered cost of equity:
Unlevered cost of equity = Rf + Unlevered Beta*(Market risk premium) = 10.50% + 0.75(9.23%) = 17.45%
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Step 2 (a): Estimate the tax benefits from debt using the fixed debt approach If the market value of Tubes existing debt is $1,807.3 million and the tax rate is 30%, then:
PV of expected tax benefits in perpetuity = (Debt)*(Interest rate on debt)*(Corp. tax rate) (rd) = Debt* Corp. tax rate = (1,807.3) * (0.30) = $542.2 million
Tube Corp. case study: valuation using APV (contd) Step 2 (b): Estimate the tax benefits from debt using the rebalanced debt approach
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In year 0, Tubes market value of debt was $1,807.3 million and the market value of equity was $2,282.0 million, thus the debt to equity ratio is 79.2% In years 1 and 2 the market value of equity increases by 5% annually, thus in order the maintain the D/E ratio of 79.2%, debt would have to increase:
Year 1: D = $1,897.7 = 79.2% E $2,396.1 Year 2: D = $1,992.6 = 79.2% E $2,515.9
Thus, the PV Tax Shield(year x) = (Debt)*(Interest rate on debt)*(Corp. tax rate) (1 + unlevered cost of equity) x
Yr. 1 = $1,897.7 * .12 * .30 = $58.2 million (1+.1745)1 Yr. 2 = $1,992.6 * .12 * .30 = $52.0 million (1+.1745)2
In year 3 (final year of projections), the market value of equity increases by 5% to $2,641,7 million thus requiring debt to increase to $2,092.2 million, thus:
Yr. 3 = $2,092.2 * .12 * .30 = $46.5 million (1+.1745)3 PV Tax Shield(year 3) = (Debt) * (Interest rate on debt) * (Corp. tax rate) (rd) (1+ re) 3 = $ 387.4 million
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Step 3: Estimate expected bankruptcy costs To estimate, assume that based on the companys existing rating, the probability of default at the existing debt level is 10% and that the cost of bankruptcy is 40% of unlevered firm value, thus:
Expected bankruptcy cost = Prob. of bankruptcy * Cost of bankruptcy *Unlev. firm value = 0.10*.0.40*$1,704.6 = $68.2 million
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In order for the APV approach to be equivalent to the WACC approach, it must incorporate a cost of financial distress, which is calculated as the probability of bankruptcy (default) multiplied by the direct and indirect costs of bankruptcy At lower levels of leverage, the effective probability of default is so low that it is not even worth calculating the costs of financial distress. Where leverage levels rise, cost of financial distress calculations become not only necessary but also informative
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Valuations of project financings When there are changing debt structures Situations involving tax loss carryforwards In order to optimize debt levels As a check against other DCF valuation methods