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Original Title: FM_APV

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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)

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

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.

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.

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 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

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