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The Adjusted Present Value approach (APV)

APV approach begins with the value of the firm without debt. While debt is added
to the firm, the net effect on the value of the firm is examined by considering
both the benefits and the costs of borrowing. In these case, the assumption is
that the primary benefit of borrowing funds is the tax benefit, and the most
significant cost of borrowing is the additional risk of bankruptcy. Thus, in the
adjusted present value approach, the value of the firm is written as the sum of
the value of the firm without debt (the unlevered firm) and the effect of debt on
firm value.
Firm Value= unlevered firm value + (Tax benefit of debt Expected bankruptcy
cost from the debt)
Mechanics of APV valuation
To estimate the value of the firm, the steps are as follows:
(i)
(ii)
(iii)

Estimate the value of the firm with no leverage


Consider the present value of the interest tax savings generated by
borrowing
Evaluate the effect of borrowing on the probability that the firm will go
bankrupt and its expected cost of bankruptcy

Value of unlevered firm


Valuation of a firm as if it had no debt can be done by discounting the expected
free cash flow to the firm at the unlevered cost of equity.
Value of unlevered firm = FCFF0(1 + g)/(Pu - g)
Where FCFF0 is the current after-tax operating cash flow to the firm, r u is the
unlevered cost of equity and g is the expected growth rate. The inputs needed
for this valuation are the expected cash flows, growth rates and the unlevered
cost of equity. Where unlevered cost of equity can be calculated by using
unlevered beta of that firm, which is
unlevered = current/[1 + (1 t)D/E]
Where unlevered = Unlevered beta of the firm
current = Current equity beta of the firm
t = Tax rate for the firm
D/E = Current debt/equity ratio
Then unlevered beta can be used to arrive at the unlevered cost of equity.
Expected tax benefit from debt
Tax benefits can be estimated by the tax rate and the interest payment of the
firm. This is discounted at cost of debt to show the riskiness of the cash flow. If
the tax benefits are seen as a perpetuity then,
Value of tax benefits = (Tax rate X Cost of debt X Debt)/Cost of Debt
= Tax rate X Debt = t cD
It is assumed that the tax rate here is the marginal tax rate for the firm, and it is
constant over time.

Estimating expected bankruptcy costs and effects


The next step is to evaluate the level of debt on the risk of the firm, and on the
expected cost of bankruptcy. This requires an estimation of probability of default
with additional debt and the cost (direct and indirect) of bankruptcy.
PV of expected bankruptcy cost = Probability of bankruptcy X PV of bankruptcy
cost
= aBC
Where a is the probability of default after additional debt and BC is the present
value of the bankruptcy cost. As both probability of bankruptcy and bankruptcy
cost cannot be estimated directly, so this method has major problems of
estimation. To estimate the probability of bankruptcy, there are two methods.
One method is to estimate the bond ratings and use empirical estimate of
default probabilities for the corresponding ratings. For example, the figure below
shows the probability of getting default with respect to bond ratings.

Bond Rating Default Rate

100.00%

80.00%

CC

65.00%

CCC

46.61%

B-

32.50%

26.36%

B+

19.28%

BB

12.20%

BBB

2.30%

A-

1.41%

0.53%

A+

0.40%

AA

0.28%

AAA

0.01%

The other method is to use a statistical approach, such as a probit to estimate


the probability of default, based on the firms observable characteristics, at each
level of debt.
The bankruptcy cost can be estimated from studies that have looked at
the magnitude of this cost in actual bankruptcies. Research that has looked at
the direct cost of bankruptcy concludes that they are small, relative to firm
value. The indirect costs of bankruptcy can be substantial, but the costs vary
widely across different firms. Shapiro and Titman speculate that the indirect
costs could be as large as 25% to 30% of firm value but provide no direct
evidence of the costs.
Finally, Firm Value= unlevered firms value + (Tax benefit of debt Expected
bankruptcy cost from the debt)
Or, Firm Value = FCFF0(1 + g)/(Pu - g) + tcD - aBC