APV Notes - Fnce 207

9/25/2018
Chapter 5
The Adjusted Present Value (APV)

and Weighted Average Cost of
Capital (WACC) Discounted Cash
Flow Valuation Models
© Robert W. Holthausen Corporate Valuation - Chapter 5 1
Discussion Topics
© Cambridge Business Publishers 2019 2 Corporate Valuation by Holthausen & Zmijewski
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Creating Value from Financing

 Miller and Modigliani’s seminal thinking and
insights
 The Single Investor Company
 Countervailing forces
Miller and Modigliani’s

Seminal Thinking and Insights
 Based on assumptions that set up “perfect markets”
 Competitive market
 No transactions costs (no fees, no bankruptcy costs, …)
 No arbitrage profits
 Everyone can borrow or lend at the same rate
 Everyone has the same information
 Everyone can write complete contracts on any type of asset and
size of asset
 Wrote two papers – one assuming no income taxes and then
added income taxes with tax deductible interest
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 Modigliani & Miller in a world without taxes
 The weighted average cost of capital and the value of firm are not
affected by capital structure (debt vs. equity), holding investment
policy fixed
 The weighted average cost of capital is equal to the unlevered or
asset cost of capital
 Simple idea – holding investment policy fixed, the value of the
assets of the firm is not affected by how you split the cash flows
among claims
 Cost of equity capital increases as the firm uses more non-
common equity financing because equity has more risk

 Modigliani & Miller in a world with taxes and interest is tax
deductible
 The weighted average cost of capital and value of firm are affected by capital
structure (debt vs. equity), holding investment policy fixed because of the tax
deductibility of interest
 The weighted average cost of capital is less than the unlevered or asset cost of
capital
 The value of the firm increases by the present value of the tax savings from
the interest deductions
 Simple idea – holding investment policy fixed, the value of the unlevered
assets of the firm is not affected by how you split the cash flows among claims
but we now have another asset, the value of interest tax shields
 Cost of equity capital still increases as the firm uses more non-common equity
financing because equity has more risk, but the increase in the risk is reduced
because of the tax deduction for interest
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The Single Investor Company

 Assume a company is owned and managed by one
investor – thus, it has no agency cost type conflicts
 The company is all equity financed, $100,000
 The company has $80,000 in revenue and $15,000 EBIT
and an income tax rate of 1/3 (33.33%)
 The company’s net income is $10,000 (2/3 x $15,000) and
has an ROA = ROE = 10% (company is unlevered)
 Can the investor benefit if the investor changes the capital
structure to include $60,000 of debt, 5% interest rate that
the investor finances (no agency conflicts)?
 Interest is not tax deductible

 Can the investor
benefit if the
investor changes
the capital
structure to
include $60,000
of debt with a
5% interest rate
when interest is
not tax
deductible?
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 No value is
created from
financing the
company with
debt
 Total cash flow
to investors is
$10,000,
regardless of
financing
 We only sliced
up the pie in a
different way –
some to debt
and some equity

 What happens to the return on equity?
 All equity, ROE = $10,000 / $100,000 = 10%
 Levered, ROE = $7,000 / $40,000 = 17.5%
 What is the overall rate of return, ROA?
 ROA Unchanged 10% ($10,000 / $100,000)
 Is the equity investor better off?
 Is the Levered ROE always greater than the all equity ROE?
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 If ROA < the
after-tax cost of
debt, ROE < all
equity ROE
(interest is not tax
deductible so the
after-tax cost of
debt is the cost of
debt)
 Expected return is
higher but so is the
risk
 No better or worse
off, just different
risk/return profile

 What if interest becomes tax deductible?
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 By deducting
interest, the
company saves
$1,000 in
income taxes
 Total cash flow
to investors is
$11,000 because
of the income
tax saved
 Interest tax
shields increase
cash flows to
investor and
thus, create
value
 What if interest becomes tax deductible?

 Total cash flow to investors is now $11,000
 All equity, ROE = $10,000 / $100,000 = 10%
 Levered with interest not tax deductible,
ROE = $7,000 / $40,000 = 17.5%
 Levered with tax deductible interest,
ROE = $8,000 / $40,000 = 20%
 And ROA is no longer 10% as before, but now is
ROA = 11% = $11,000 / $100,000
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 What is the interest tax shield?
Interest Tax Shields

 The interest tax shield is equal to the change in
income taxes resulting from interest deductions
Income taxes paid by the company without any interest deductions
− Income taxes paid by the company after any interest deductions .
= Interest Tax Shield of the Interest Deduction
 Interest tax shields can often be measured as the

tax rate applicable to the interest deduction x tax
deductible interest expense
ITS = TINT x INT
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Interest Tax Shields

 Potential complications in calculating interest tax
shields
 Net Operating Losses (carryback and carryforward)
 Measuring the marginal tax rate for interest, TINT
 Timing difference between when interest is accrued and

when it is deductible
 Capitalized interest
 Pay-in-kind debt (AHYDO rules)
 Too little profit to capture benefit or government limits
Countervailing Forces
 We do not observe companies maximizing debt to maximize the
value from interest tax shields
 Countervailing forces offset the benefits of ITSs
 Potential forces are real and can be large (more in Chapter 11)
 Financial distress or bankruptcy costs
 Agency costs between owner/managers and debtholders (such as enforcing bond
covenants)
 Difference in personal income tax rates between investor returns on equity and
debt
 Will the company be sufficiently profitable to use the interest deduction?
 Conclusion – debt creates some value, depending on the magnitude of the
countervailing forces
 Could also have other value from financing from a government subsidized
interest rate, but this is less common
 For our purposes, we’ll assume the value created from financing is equal to the
value of the interest tax shields, VFIN = VITS for now
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Creating Value from Financing, VFIN

 Summary
 A company can create value if it can issue debt or other
non-common equity security at a subsidized rate
(relative to the true opportunity cost of capital)
 As we discussed, tax deductible interest is a form of
subsidizing debt financing
 Also, states and municipalities, in attempting to attract
business, may let corporations issue tax-free bonds,
which lowers the rate of return required by investors
Creating Value from Financing, VFIN

 The value of the firm is
VF = VUA + VFIN – CostsCvf
VF = value of the firm
VUA = value of the unlevered firm or assets
VFIN = VITS = value from financing = value from interest
tax shields + other subsidies
CostsCvf = cost of countervailing forces such as
financial distress costs
 Generally, we will assume the cost of countervailing forces is equal
to zero for now – so the value of the firm is now
VF = VUA + VITS
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The APV and WACC

Valuation Models
 The adjusted present value valuation model
 The weighted average cost of capital valuation
model
 The links between unlevered, weighted
average and equity costs of capital (overview,
discussed in more detail in Chapters 10 and
11)
 The APV and WACC valuation models are not
substitutes
The All Equity Financed Firm

 From Chapter 1, assuming a company does not
use debt
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The All Equity Financed Firm

 From Chapter 1, assuming a company does not use
debt
 What if the company has debt?

 How do we include the value of the interest tax shields?
Overview of APV and WACC

 Why two methods?
 The two DCF methods have different ways of embedding the value
of the interest tax shields
 The APV method values the unlevered assets and interest tax shields
separately
 The WACC method incorporates the value of financing by adjusting the
discount rate and values both components together (sometimes called the
adjusted cost of capital method)
 The two methods are algebraically equivalent but one method
typically dominates for a specific valuation context
 Both methods are useful because each has advantages and
disadvantages
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The APV Valuation Model

 Value of the firm obtained by
 Discounting expected free cash flows of the unlevered firm at
the unlevered cost of capital (i.e., as if it were 100% equity
financed), rUA
 Discounting expected interest tax shields at the appropriate
discount rate, rITS
 For now, we assume that the appropriate discount rate for interest tax
shields is equal to the unlevered cost of capital, rITS=rUA
 In Chapter 10, we explore this topic in much more detail
 The APV method is preferred when we have forecasts of
the year-by-year debt schedule and the capital structure
proportions vary through time and we do not know those
proportions
The APV Valuation Model

 The APV valuation method
 Using the cash flow perpetuity for continuing value
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The WACC Valuation Model

 Value of the firm obtained by
 Discounting the forecasted free cash flows of the unlevered
firm (i.e., as if it were 100% equity financed) at the weighted
average cost of capital (WACC)
 Preferred method when capital structure ratios (e.g., debt
to value ratio, preferred to value ratio) are known and
assumed to be constant or at least known for each period
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The Links Between the Methods –

Recall the Economic Balance Sheet
 The economic balance sheet equalities:
Value of the Firm = Value of Non-Equity Claims
+ Value of Equity
Δ Value of the Firm = Δ Value Non-Equity Claims
+ Δ Value Equity
$ Return of the Firm = $ Return Non-Equity Claims
+ $ Return Equity
The Links – What is the

Unlevered Cost of Capital, rUA?
 We use the economic balance sheet (market values)
to show the link between rUA and the other costs of
capital (assuming rITS =rUA)
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The Links – What is rWACC?

 The unlevered cost of capital is equal to the capital structure
weighted before tax costs of capital of the securities used to finance
the firm
 The weighted average cost of capital is equal to the capital structure

weighted after-tax costs of capital of the securities used to finance
the firm
 Multiply rD by 1-TINT when interest is tax deductible at the

corporate level
The Links – What is rWACC?

 The WACC method is sometimes called the
adjusted cost of capital method because it “adjusts”
the unlevered cost of capital downward to reflect
the benefit of the interest tax shields
 The difference between the weighted average cost
of capital and the unlevered cost of capital
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The Links – What is the

Equity Cost of Capital, rE?
 The equity cost of capital is equal to the unlevered
cost of capital adjusted for the use of financial
leverage (from debt or preferred stock)
APV and WACC Valuation Models

Are Not Substitutes
 Depending on the information available and
valuation assumptions, only one of the two
methods is typically the appropriate starting point
for a valuation
 In what ways are the two valuation models the
same and in what ways are they different?
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Information Requirement Differences

APV versus WACC
No ITS
Same free Different discount rates separate in
cash flows rWACC ≤ rUA WACC
method
Information Requirement Differences

APV versus WACC
APV Valuation Method WACC Valuation Method
 Cash flows  Cash flows
 Unlevered free cash flows  Unlevered free cash flows
 Interest tax shields (usually requires
debt forecasts and tax rate, TINT)  Weighted average cost of capital
 Costs of capital  Capital structure strategy is fixed
 Unlevered cost of capital proportions (ratios) in terms of
 Discount rate for interest tax shields market values
 Continuing value  Cost of capital for each security used
to finance the company
 Continuing value the unlevered firm
and continuing interest tax shields OR  Tax rate for interest, TINT
 Continuing value of the levered firm  Continuing value of the levered firm
(sum of the parts)  Assume constant capital structure as
 Sometimes assume constant capital of the continuing value date
structure as of the continuing value
date
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APV and WACC Valuation Models

Are Not Substitutes
 To measure expected interest tax shields
 Debt cost of capital
 Tax rate for the interest tax shields
 Amount of debt (dollar magnitude)
 To measure rWACC
 Cost of capital for equity, debt, preferred stock, …
 Tax rate for interest
 The proportion of the firm financed with each security
(measured in terms of market values)
 What do we know if we know the amount of debt in each
period and the proportion of the firm financed with debt?
A Quick APV – WACC Example

 The company is expected to generate unlevered free cash flows of
$3,000 per year in perpetuity (no growth)
 The company was initially financed with $10,000 equity
 The company has $12,000 debt (8% cost of capital) and $8,000
preferred stock (9% cost of capital) – the company does not intend
to change its capital structure
 The company’s income tax rate on all income statement items is
40%, and interest is tax deductible
 The company’s unlevered cost of capital is 10%
 The appropriate discount rate for interest tax shields is the
unlevered cost of capital for this company (rINT = rUA)
 What is your starting valuation method?
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 Known magnitude of debt financing, use the APV
valuation method
VUA = FCF / rUA
= $3,000 / .1 = $30,000
VITS = ITS / rUA
= ($12,000 x 8% x 40% ) / .1 = $3,840
VF = $30,000 + $3,840 = $33,840
VE = VF – VD – VPS
= $33,840 - $12,000 - $8,000 = $13,840

 Now that we know the value of the firm we can
measure the capital structure ratios
 Debt to value = $12,000/$33,840 = 35.5%
 Preferred stock to value = $8,000/$33,840 = 23.6%
 Equity to value = $13,840/$33,840 = 40.9%

 What is rWACC – first measure the equity cost of
capital, rE
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 What is rWACC?

 The WACC valuation is
VF = FCF/rWACC
= $3,000 / .088652 = $33,840
 The two valuations are identical, the APV and
WACC methods are algebraically equivalent
 Note – had we instead known the D/V and PS/V
ratios and not the amount of debt outstanding, the
WACC valuation would have been the starting
point
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The Bottom Line on APV & WACC

 The two valuations are identical, the APV and
WACC methods are algebraically equivalent
 Best starting point
 WACC if you have known capital structure ratios
 APV if you have known amounts of debt
Valuing Common Equity

 Using the APV and WACC valuation methods
 Discounting equity free cash flows
 Discounting dividends
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Using the APV and WACC Valuation

Methods to Value Equity
 To use the APV and WACC methods
 Measure the value of the firm
 Subtract non-common equity claims from the value of the firm
to measure the value of the common equity
 Can we discount equity free cash flows at the equity cost

of capital to directly measure the value of the equity?
 Of course, if we know all of the inputs
 Discounting equity free cash flows is algebraically equivalent to
the APV and WACC valuation methods
Discounting Equity FCFs

 The basic formula
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Back to the Quick Example

 What are the equity free cash flows in our example?
 No growth perpetuity
 No change in financing
 Recall calculation for equity free cash flows (Chapter 3)
Unlevered Free Cash Flow

− Cash interest and preferred stock dividends
+ Interest tax shield .
Free cash flow before changes in financing
+ Increases in non-common equity financing
− Decreases in non-common equity financing .
Equity free cash flow

$3,000 Unlevered Free Cash Flow
− 960 Cash interest (.08 x $12,000)
− 720 Preferred stock dividends (.09 x $8,000)
+ 384 Interest tax shield (40% tax rate x 960) .
$1,704 Free cash flow before changes in financing
+ 0 Increases in non-common equity financing
− 0 Decreases in non-common equity financing .
$1,704 Equity free cash flow
Recall the equity cost of capital
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 Discounted equity free cash flows
VE = EFCF1 / rE
= $1,704 / .12312 = $13,840
 The three valuations are identical, the APV,
WACC, and E-DCF methods are algebraically
equivalent
 What are the information requirements of the
equity DCF valuation method?
Information Requirements for E-DCF

Must know
$3,000 Unlevered Free Cash Flow the amount
− 960 Cash interest (.08 x $12,000) of debt and
preferred
− 720 Preferred stock dividends (.09 x $8,000) stock to
+ 384 Interest tax shield (40% tax rate x 960) .
measure
$1,704 Free cash flow before changes in financing equity free
cash flows
+ 0 Increases in non-common equity financing
− 0 Decreases in non-common equity financing Must .know
$1,704 Equity free cash flow the capital
structure
ratios to
measure the
equity cost of
capital
If you know
all that, what
do you know?
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Bottom Line on Equity DCF
 The information requirements include

 Amount of non-common equity financing (to measure interest
and preferred stock dividends)
 Non-common equity capital structure ratios (to measure the
equity cost of capital)
 Generally, avoid using this method when possible
 One can make assumptions about the capital structure
ratios and levels of non-common equity financing – if the
assumptions are close to the actual underlying
assumptions, the valuation difference can be small
Implementation Details
 Interest Deduction Limitations
 Adjusting for inflation
 Expected free cash flows – what are they?
 Risk-adjusted discount rates and the certainty
equivalent approach
 Do not use fudge factors
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Interest Deduction Limitations

 Recall from Chapter 3, interest deduction limitations (caps) can
affect the value of the firm because they can defer the tax benefit
from interest tax shields (many countries, including the U.S. since
the passage of the Tax Cuts and Jobs Act of 2017, set limitations on
the extent to which a company can deduct interest to reduce its
taxable income)
 Because the APV valuation model discounts expected interest tax
shields directly, the APV valuation incorporates any effect of interest
deduction caps
 The WACC valuation model assumes that the company receives the
tax benefit from interest tax shields each year, which will overstate
the value of the interest tax shields; thus, the WACC valuation model
must be adjusted for the deferral of interest tax shields resulting
from interest deduction caps (see, Chapter 11)
Nominal versus Real

 We can value a firm using
 Nominal cash flows and nominal discount rates
 Real cash flows and a real discount rate
 The relationship between nominal and real rates is
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Nominal versus Real

 A company operates in a high inflation country
 Free cash flow for Year 0 is $1,000
 Cash flow will grow at 12.2% in perpetuity
 Inflation is 10% and expected to continue in perpetuity
 Nominal cost of capital is 15.5%
 Nominal valuation
VF = FCF0 x (1+gnominal)/(rnominal – gnominal)
= $1,000 x (1.122)/(.155-.122) = $34,000
 Real valuation
VF = FCF0 x (1+greal)/(rreal – greal)
Nominal versus Real
 Real valuation
greal = (1+gnominal)/(1+inflation)-1
= 1.122/1.1 – 1 = .02
rreal = (1+rnominal)/(1+inflation)-1
= 1.155/1.1 – 1 = .05

= $1,000 x 1.02/(.05 - .02)=$34,000
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What Are Expected Free Cash Flows?

 Recall from Chapter 4, expected cash flows are
 Not the most likely scenario
 Represent the probability weighted average of all the
possible outcomes
 We take into account all uncertainty in the cash
flows
 That includes unlikely events such as
 Bankruptcy or technical default
 Death of key CEO
 Product failure, weather, …
Risk-Adjusted Discount Rates

 Discount expected future cash flows at a risk-adjusted
discount rate
 The risk-adjusted discount rate (also called cost of capital,
required return, opportunity cost of capital, hurdle rate)
depends on
 Real (inflation free) risk-free rate,
 Expected inflation, and
 Non-diversifiable risk of the expected future cash flows
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 The “risk” in the risk-adjusted discount rate is determined
by the risk that investors can’t mitigate through
diversification
 This risk is not the same as the uncertainty in the cash
flows – we account for all uncertainty in cash flows
 Any risk that is totally diversifiable shouldn’t be priced
 Non-diversifiable risk increases a company’s risk adjusted
discount rate

 Assume these are the only two investments in existence, the payoffs
for both investments occur at the end of one year
 Price of A is $400 and the price of B is $800
 Which investment has more uncertain cash flows and which should have a
higher discount rate? What is the discount rate?
 Which investment do you purchase?
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 What is the expected payoff of each investment?

 What is the payoff in each state and the expected payoff if the
investor purchases an equally weighted portfolio of both
investments?
 The payoff is constant in all states – eliminated all risk – complete

diversification – risk-adjusted discount rate = risk-free rate
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Fudge Factors – Don’t Use Them

 In the DCF valuation model, we discount
expected future cash flows at a risk-adjusted
discount rate
 When measuring expected cash flows, we consider
all of the uncertainty in the cash flows – that is,
consider uncertainty due to the systematic as well
as unsystematic factors
 Do not add an adjustment to the discount rate for
non-diversifiable risk, but use it to measure the
expected free cash flows

 Suppose a company’s free cash flow, in perpetuity,
will be
 $133 if the economy is bad (30 percent probability),
 $500 if it is good (40 percent probability), and
 $1,200 if it is booming (30 percent probability)
 The expected value of the company’s free cash flow is

$600
($600 = .3 x $133 + .4 x $500 + .3 x $1,200).
 If the company’s discount rate is 10 percent, the value
of the company is $6,000 ($6,000 = $600 / .1)
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 Assume that the success of the company is entirely
dependent on the owner/manager remaining in good
health for the next year (20% probability)
 If the manager lives the expected cash flows are $600 in
perpetuity and if manager dies the cash flows will be $0
 You sometimes see a valuation with an adjustment to the
discount rate for such uncertainty
 Let’s add a 5 percent risk adjustment and use a 15% discount rate
 The company’s value is $4,000 ($4,000 = $600 / .15)
 The 5% is a “fudge factor” and is ad hoc as we do not know how much
to alter the discount rate
 Sometimes called the build-up method for measuring the cost of capital

 This uncertainty does however, change the expected free
cash flows of the company
 20% chance of having $0 free cash flows
 80% chance of having an expected free cash flow of $600 (in
perpetuity)
 Adjust the company’s expected free cash flow for this uncertainty
$480 ($480 = .2 x $0 + .8 x $600 = .8 x $600)
 The resulting value of the company is $4,800 ($4,800 = $480 / .1)
 Given this knowledge, we could adjust the discount rate by
2.5% to measure the same value but only know the right
adjustment to the discount rate because we know the value
$4,800 = $600 / .125
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Changing Discount Rates

 Discount rates change if the company’s systematic
risk changes; for example
 Change in the company’s capital structure
 Change in its operations
 To measure a present value with changing

discount rates
The Laid-Back Fishing Company Valuation

 The transaction
 The initial forecasts (pre-sale, original owner)
 Weighted average cost of capital valuation
 The revised forecasts (post-sale, new owner)
 Better operating performance
 Additional debt
 Adjusted present value valuation
 Reconciliations (WACC to APV, APV to WACC)
 Equity discounted cash flow valuation
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The Laid-Back Fishing Company Valuation

 The Laid-Back Fishing Company (Laid-Back) has forecasts
that everyone agrees are reasonable expected values
 The owners use a target capital structure of 20% debt and 80%
common equity, with a debt cost of capital of 8%
 The company did not forecast its debt levels but left the debt
equal to its current level in the forecasts, even though the
company plans to continue its current capital structure strategy
 The company believes its free cash flows will grow in perpetuity
at 2% beginning in Year 5
 Laid-Back’s unlevered cost of capital is 12%
 Income tax rate is 40%
 Management is considering buying the company from the
owners
The Seller’s Capital Structure:

Laid-Back’s
Initial Forecast and
WACC Valuation
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Laid-Back’s Initial Forecasts
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Laid-Back’s rE and rWACC

 What is the equity cost of capital?
 What is rWACC?

WACC Valuation
 Laid-Back’s WACC valuation using initial forecasts
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WACC Valuation
 Laid-Back’s WACC valuation using initial forecasts
The Seller’s Capital Structure:

Measuring the Value of the
Unlevered Firm and the Value of the
Interest Tax Shields Embedded in
the WACC Valuation
(WACC Valuation Method to APV Valuation Method)
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Laid-Back’s APV Valuation

of Laid-Back’s Initial Forecasts
 We know the company’s unlevered free cash flows
but we do not know the correct interest expense or
interest tax shields because the debt in the balances
sheet is not the debt assumed in the WACC
valuation
 To use the APV method in a valuation with known
capital structure ratios but unknown debt levels, we
measure the value of the company each year using
the WACC valuation method
Laid-Back’s Year-by-Year WACC

 Year-by-year WACC valuation – start with the
continuing value and work backwards (initial forecasts)
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Laid-Back’s Year-by-Year WACC

 Year-by-year WACC valuation – start with the
continuing value and work backwards (initial
forecasts)
Laid-Back’s Year-by-Year ITSs

 Year-by-year interest tax shields implied in the WACC
valuation (initial forecasts)
 Calculate the amount of debt
 Calculate the amount of interest
 Calculate the interest tax shield
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Laid-Back’s WACC to APV Reconciliation

 Now that we know the interest tax shields embedded in the WACC
valuation, we can use the APV method based on the initial forecasts
Laid-Back’s WACC to APV Reconciliation

 Now that we know the interest tax shields embedded in the WACC
valuation, we can use the APV method based on the initial forecasts
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Reasons to Calculate the Implicit Capital

Structure in the WACC Valuation
 One advantage of calculating the interest expense that is
implicit in the WACC valuation is to make sure that the
interest expense will not be subject to any interest
expense caps in the tax code (be fully deductible)
 Incorporating the implicit WACC valuation capital
structure allows you to:
 Understand the feasibility of the capital structure embedded
in the WACC model
 Determine the feasibility of servicing the debt requirements
 Determine whether you meet covenant constraints
 Understand the cash flows available for distribution to

equityholders
The Buyer’s Capital Structure:

Laid Back’s Revised Forecasts and
Capital Structure
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Laid-Back’s Revised Forecasts

 The transaction
 The owners agreed to sell the company to management for $22 million, a 10%
premium over the WACC valuation – management assumes all operating
liabilities
 Management will finance the transaction with $17 million in debt (9 percent
cost of debt and interest rate) and $5 million in common equity (we assume
there are no binding interest rate caps on the tax deductibility of interest)
 Management will use its available cash to reduce debt in Years 1 through 3 and
then grow debt with the free cash flow growth rate
 Management believes it can improve performance and revised the
forecasts
 Decrease operating expenses from 51.9% of revenues to 51% of revenues
 Decrease required cash from 20% of revenues to 15% of revenues
 Decrease net working capital from 40% of revenues to 35% of revenues
 Slightly decrease capital expenditures but generate the same revenues
 What is the value of the firm and the value of the equity?
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Laid-Back’s Revised Forecast and

APV Valuation
 Use the APV valuation method (revised forecasts)
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Laid-Back’s Revised Forecast and

APV Valuation
 Use the APV valuation method (revised forecasts)
The Buyer’s Capital Structure:

Using the WACC Valuation Model
with a Changing Capital Structure
(APV Valuation Model to WACC Valuation Model)
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Laid-Back’s APV to WACC Reconciliation
 For the revised forecasts, we can measure the value of

Laid-Back each year and measure the embedded capital
structure ratios
 Once we know the capital structure ratios each year, we
can measure the equity and weighted average costs of
capital each year
 Once we know the weighted average cost of capital each
year, we can use the WACC method to value the company
using the revised forecasts
 To measure the year-by-year values, start at the continuing
value and work backwards
Laid-Back – Year-by-Year APV
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Laid-Back – Year-by-Year APV
Laid-Back’s – Revised Forecast

Year-by-Year Capital Structure Ratios
 We use the year-by-year valuations and the amount
of debt in the revised forecasts to measure the year-
by-year capital structure ratios
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Year-by-Year Equity Costs of Capital
 We use the year-by-year capital structure ratios to measure
the year-by-year equity costs of capital
 Note the decreasing rE – what will happen to rWACC?

Year-by-Year Equity Costs of Capital
 We use the year-by-year capital structure ratios to
measure the year-by-year equity costs of capital
 Note the decreasing rE – what will happen to

rWACC?
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Year-by-Year Weighted Average Costs of Capital
 We use the year-by-year equity costs of capital to measure the year-
by-year weighted average costs of capital
 Note the increasing rWACC

 We use the year-by-year equity costs of capital to measure the year-
by-year weighted average costs of capital
 Note the increasing rWACC

 What is the Year 4 rWACC versus rWACC used for the initial forecasts –
why are they different?
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 We didn’t need the year-by-year equity costs to

measure the year-by-year weighted average costs of
capital

 Once we have the year-by-year weighted average
costs of capital, we can measure Laid-Back’s value
using the WACC method (revised forecasts)
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9/25/2018

 Once we have the year-by-year weighted average costs of
capital, we can measure Laid-Back’s value using the WACC
method (revised forecasts)
 Note the WACC CV ($28,551.6) is the same as the CV
from the APV DCF.
Why Did Laid Back’s

Value Increase
from $22,000 to $28,000?
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Laid-Back’s Increase in Value

 What caused Laid-Back’s increase in value?
 Better performance – increased free cash flows
 Increased interest tax shields
 What is the difference in the free cash flows?

 What is the difference in the interest tax shields?
Laid-Back’s Increased Value
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Laid-Back’s Equity Discounted

Value Flow Valuation
Laid-Back’s Equity DCF Valuation

 We use the equity DCF valuation based on both the Seller’s and
Buyer’s capital structures, but the set of calculations is not identical
 Required information to use the equity DCF valuation method:
 Equity cost of capital
 Equity free cash flows
 Seller’s (Initial) forecasts and constant 20% debt capital structure:
 We know the equity cost of capital, which is constant
 We do not know the equity FCFs because the initial forecasts did not use the
debt values implied in the WACC valuation, but we know those now
 Buyers (Revised) forecasts and varying capital structure:
 We know the equity FCFs because the revised forecasts used the debt values
the company expects to have in each year
 We do not know the equity cost of capital and it changes because D/V
changes each year
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Laid-Back’s Equity DCF Valuation for Seller’s

(Initial) Forecasts and 20% Debt Capital Structure
 For the initial forecasts, use the year-by-year
implicit debt, interest and interest tax shields
forecasts to measure the equity free cash flows
based on the debt embedded in the WACC
valuation

 For the initial forecasts, use the year-by-year debt, interest
and interest tax shields forecasts to measure the equity free
cash flows based on the debt embedded in the WACC
valuation
 Since the EFCF4 grew at the perpetuity growth rate of 2%,

we can use EFCF3 to measure the continuing value
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 We can now use the equity DCF method to value
the common equity based on the initial forecasts
with a constant capital structure assumption

 Use the equity DCF method for the 20% debt capital structure
57
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Laid-Back’s Equity DCF Valuation for Buyer’s

(Revised) Forecasts and Capital Structure
 For the revised forecasts, use the forecasts to
measure the equity free cash flows
 Use year-by-year APV valuation to measure the
equity cost of capital for each year
Recall Buyer’s Revised Forecasts
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 We know the equity free cash flows in the revised forecasts reflect
the expected capital structure
 But we need to know the varying cost of equity capital (fortunately,
we have already measured it).
 Note – the unlevered and equity free cash flows have to grow at the
same rate for the different methods to yield the same valuation

 We have year-by-year equity costs of capital and the equity free cash
flows from the revised forecasts reflect the expected capital structure
 Note – the unlevered and equity free cash flows have to grow at the
same rate for all the methods to yield the same answer
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Laid-Back Takeaways
 WACC DCF method is directly implementable when
capital structure ratios are known – APV method is not
 APV DCF method is directly implementable when dollar
magnitudes of debt, interest and interest tax shields are
known – WACC DCF method is not
 WACC and APV methods yield the same value if given
the same information but we always have to solve for the
value of the firm each period to use the other method
 Equity DCF method is never directly implementable as
must always solve for the value of the firm in each period
to determine the equity cost of capital or EFCF
What We Covered
60
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Key Concepts and Takeaways - 1

 Subsidized financing through tax deductibility (such as
interest tax shields) or through other subsidies – can
increase the value of the firm by increasing the cash flows
available to all investors
 Without such a subsidy, using debt or preferred financing
increases the risk and therefore the expected return for
equity but the equityholders are no better off and the
value of the firm does not increase
 Countervailing forces may potentially reduce the value of
the interest tax shields

 The interest tax shield is equal to the change in income
taxes resulting from interest deductions
Income taxes paid by the company without any interest deductions

− Income taxes paid by the company after any interest deductions
= Interest Tax Shield of the Interest Deduction
 Interest tax shields are often measured as the tax rate x interest
ITS = TINT x INT
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Key Concepts and Takeaways – 3

APV versus WACC
The APV method values
interest tax shields directly
No ITS
Same free Different discount rates separate in
cash flows rWACC ≤ rUA WACC
method
The WACC method embeds the value of interest tax

shields by adjusting (reducing) the discount rate

 A company’s costs of capital are linked:
62
9/25/2018

 When do we use each valuation method?
 Known capital structure ratios but unknown levels of debt – the
WACC method is probably the best starting point
 Known levels of non-equity financing in terms of their dollar
magnitude but unknown capital structure ratios – the APV
method is probably the best starting point
 The equity DCF method is usually not the best starting point
 It is often informative to reconcile one valuation method
with the other
 Start with WACC and reconcile to APV and equity DCF
 Start with APV and reconcile to WACC and equity DCF
 Often useful to know implied capital structure from
WACC valuation
*** END ***

Chapter 5
The Adjusted Present Value (APV) and
Weighted Average Cost of Capital (WACC)
Discounted Cash Flow Valuation Models
63

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The Adjusted Present Value (APV)

© Robert W. Holthausen Corporate Valuation - Chapter 5 1

© Cambridge Business Publishers 2019 2 Corporate Valuation by Holthausen & Zmijewski

Creating Value from Financing

© Robert W. Holthausen Corporate Valuation - Chapter 5 3

Miller and Modigliani’s

© Robert W. Holthausen Corporate Valuation - Chapter 5 4

Miller and Modigliani’s

© Robert W. Holthausen Corporate Valuation - Chapter 5 5

Miller and Modigliani’s

The Single Investor Company

The Single Investor Company

© Robert W. Holthausen Corporate Valuation - Chapter 5 8

The Single Investor Company

© Robert W. Holthausen Corporate Valuation - Chapter 5 9

The Single Investor Company

© Robert W. Holthausen Corporate Valuation - Chapter 5 10

The Single Investor Company

© Robert W. Holthausen Corporate Valuation - Chapter 5 11

The Single Investor Company

© Robert W. Holthausen Corporate Valuation - Chapter 5 12

The Single Investor Company

© Robert W. Holthausen Corporate Valuation - Chapter 5 13

The Single Investor Company

 What if interest becomes tax deductible?

The Single Investor Company

© Robert W. Holthausen Corporate Valuation - Chapter 5 15

Interest Tax Shields

 Interest tax shields can often be measured as the

Interest Tax Shields

 Timing difference between when interest is accrued and

 Too little profit to capture benefit or government limits

© Robert W. Holthausen Corporate Valuation - Chapter 5 17

Creating Value from Financing, VFIN

© Robert W. Holthausen Corporate Valuation - Chapter 5 19

Creating Value from Financing, VFIN

The APV and WACC

The All Equity Financed Firm

© Robert W. Holthausen Corporate Valuation - Chapter 5 22

The All Equity Financed Firm

 What if the company has debt?

© Robert W. Holthausen Corporate Valuation - Chapter 5 23

Overview of APV and WACC

© Robert W. Holthausen Corporate Valuation - Chapter 5 24

The APV Valuation Model

The APV Valuation Model

 Using the cash flow perpetuity for continuing value

© Robert W. Holthausen Corporate Valuation - Chapter 5 26

© Cambridge Business Publishers 2019 27 Corporate Valuation by Holthausen & Zmijewski

© Cambridge Business Publishers 2019 28 Corporate Valuation by Holthausen & Zmijewski

The WACC Valuation Model

© Robert W. Holthausen Corporate Valuation - Chapter 5 29

© Cambridge Business Publishers 2019 30 Corporate Valuation by Holthausen & Zmijewski

The Links Between the Methods –

© Robert W. Holthausen Corporate Valuation - Chapter 5 31

The Links – What is the

© Robert W. Holthausen Corporate Valuation - Chapter 5 32

The Links – What is rWACC?

 The weighted average cost of capital is equal to the capital structure

 Multiply rD by 1-TINT when interest is tax deductible at the

© Robert W. Holthausen Corporate Valuation - Chapter 5 33

The Links – What is rWACC?

© Robert W. Holthausen Corporate Valuation - Chapter 5 34