Adjusted Present Value

Adjusted Present Value

Compared to WACC
Find pure play firms (also need to do this for APV analysis).
Unlever each pure play firm to get unlevered beta (need to
do this for APV analysis too).
Get average unlevered beta and unlevered cost of capital
(last step for APV).

Relever unlevered cost of capital to get cost of equity:

D
re ra ra rd
E
Combine with cost of debt to get WACC:

D
D
WACC
rd 1 Tc
re
DE
DE

WOW Incorporated
WOW Inc. is considering a simple, one-year project.
At the beginning of the year, a cash outlay of $500 is
required, none of which is depreciable or deductible.
One year later the project produces earnings before
interest and taxes (EBIT) of either $1,200 or $550, with
equal probability. Hence, the expected EBIT is $875.
Assume the projects net salvage value at the end of the
year is zero and the corporate tax rate is 34% (ignore
personal taxes for the moment). Let the market return on
a one-year risk-free bond be 6%.

Risk-free Debt Capacity

Note that the project owners could borrow $349 at the
risk-free rate of 6%.
Debt up to this amount is risk-free because the worst
possible outcome is EBIT = $550.
Interest on the debt would be $349 x 0.06 = $21, so
worst-case earnings before taxes would be $550 - $21 =
$529.
Taxes at 34% come to $180. This leaves worst-case
profit after interest and taxes of $529 - $180 = $349,
enough to pay off the debt at the end of the year.

APV
The after-tax cash flows for this project are
simply -$500 at t=0 and $875 x (1- 0.34)
= $578 at t=1.
Suppose risk-adjusted rate = 12%.
Then, NPV = -500 + 875 (1-0.34)/1.12 = $16.
Financing: $349 in debt and $151 in equity.
Tax Shield = 349 0.06 0.34 = $7.
Therefore, APV = $16 + $7.

WACC

WACC = (D/V) rd (1-t) + (E/V) re.

Debt comprises 70% of the financing and equity, 30%. The tax rate,
t, is 34% and the cost of debt is 6%. The cost of levered equity is the
risk-free rate plus a premium for the business and financial risk
borne by the equity investors.
For the all-equity capital structure, ra = 12%, reflecting only
business risk.
In the levered firm, the same amount of business risk is borne by
much less equity, and a correspondingly higher risk premium is
necessary.
re = ra + D/E (ra rd) = 12 + 0.7/0.3 (12 6) = 26%.

WACC
Therefore, WACC = 0.70(6%) x (1- 0.34) + 0.30(26%) =
10.6%.
Discounting the projects unlevered cash flow of $578 by
the WACC of 10.6% gives a project value of $523 and an
NPV of $23.
This is the same answer obtained using the APV
approach.

Acme Filters: A Case Study

Roy Henry, president of IBEX Industries, has his eye on an

acquisition target: Acme Filters, a division of SL Corporation. Acme
is a mature business that has underperformed in its industry for the
past six years.
Henry has targeted the following specific opportunities for value
creation:
Acme product line will be rationalized, and some components will be
outsourced to improve the companys operating margin by 3% and EBIT
by 10%.
The same changes will reduce inventory and boost payables, producing
one-time reductions in net working capital.
Some of Acmes nonproductive assets will be sold.
Distribution will be streamlined and new sales incentives introduced to
raise Acmes long-run growth rate from 2% annually to the industry
average of 5%.

Acme Filters

The sellers representatives have indicated that SL Corporation is

reluctant to accept less than book value (currently $307 million).
Financial experts believe that a deal at book value could be
financed with about 80% debt, comprising senior bank debt,
privately placed subordinated debt, and a revolving credit facility.
Acme does not have publicly traded shares, but a few similar
companies do, and they provide benchmarks for estimating the cost
of equity. One such company, with a historical debt ratio of 45% to
50%, has an estimated cost of equity of 18%. Another, with no debt
in its capital structure, has an estimated cost of equity of 13.5%.

Acme Filters

Acme Filters

Acme Filters

Acme Filters

B
A
S
E
L
I
N
E
P
E
R
F
O
R
M
A
N
C
E
Y
e
a
r
0
Y
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a
r
1
Y
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a
r
2
Y
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a
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a
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a
x
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6
9
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T
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R
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3
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(
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n

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7
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2
6
1
7
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1
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6
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F
C
F
G
r
o
w
t
h
2
%
2
.
0
%
F 20.2617.0918.9419.638273

Margin Improvement

V
A
L
U
E
C
R
E
A
T
I
O
N
:
M
A
R
G
I
N
I
M
P
R
O
V
E
M
E
N
T
Y
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a
r
0
Y
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a
r
1
Y
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a
r
2
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3
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4
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6
8
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3
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7
9
E
B
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T
I
n
c
r
e
a
s
e
1
0
.
0
%

T
a
x
@
3
4
%
0
6
9
0
9
1
1
1
1
2
3
1
2
T
a
x
R
a
t
e
3
4
%
3
4
F
C
F
1
.
3
5
1
.
7
2
.
2
0
2
.
3
8
2
.
5
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rC
T
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m
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a
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V
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1
9
F
C
F
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w
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h
2
%
2
.
0
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F
1
.
3
5
1
.
7
2
.
2
0
2
.
3
8
2
4
.
6
N
PV
@
13.5%18.61
U
nleveragedR
ate13.50%

Working Capital Reduction

V
A
L
U
E
C
R
E
A
T
I
O
N
:
W
O
R
K
I
N
G
C
A
P
I
T
A
L
Y
e
a
r
0
Y
e
a
r
1
Y
e
a
r
2
Y
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a
r
3
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a
r
4
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r
5
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C
1
6
.
3
0
2
.
1
0
I
n
v
e
n
t
o
r
i
e
s

F
C
F
1
6
.
3
0
2
.
1
0
0
.
0
0
.
0
0
.
0
N
PV
@
13.5%15.9
U
nleveragedR
ate13.50%

Asset Sales

V
A
L
U
E
C
R
E
A
T
I
O
N
:
A
S
E
T
S
A
L
E
S
Y
e
a
r
0
Y
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a
r
1
Y
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a
r
2
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r
3
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r
4
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9
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9
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3
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4
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e
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s
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9
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3
.
4
0
0
.
0
0
.
0
N
PV
@
13.5%15.61
U
nleveragedR
ate13.50%

Higher Long-Run Growth Rate

V
A
L
U
E
C
R
E
A
T
I
O
N
:
L
O
N
G
R
U
N
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r
2
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3
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0
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0
0
.
0
0
.
0
0
.
0
N
e
w
5
5
N
PV
@
13.5%34.23
U
nlveragedR
ate13.50%

Capital Structure

C
A
P
I
T
A
L
S
T
R
U
C
T
U
R
E
Y
e
a
r
0
Y
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a
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1
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a
r
2
Y
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a
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3
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a
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4
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7
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5
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1
3
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0
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2
4
.
8
1
.
7
2
0
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9
2
0
.
0
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a
n
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L
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n
@
8
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8
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D
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t
@
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otalD
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8
1
8
1
.
7
1
7
0
.
9
1
6
0
.
0
E
quiy 664771459 72

Tax-Shield

IT
N
T
E
R
E
S
T
T
A
X
S
H
I
E
L
D
Y
e
a
r
0
Y
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a
r
1
Y
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a
r
2
Y
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a
r
3
Y
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r
4
Y
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a
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i
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7
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3
5
6
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4
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6
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0
6
5
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6
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3
8
rF
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m
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F
7
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3
5
6
.
4
8
6
.
0
6
5
.
6
9
1
2
5
.
2
3
N
PV
@
9.5%10.24

APV is Exceptionally Transparent

B
A
S
E
L
I
N
E
P
E
R
F
O
R
M
A
N
C
E
1
5
2
.
9
1
IV
N
T
R
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S
T
T
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D
0
2
4
A
LUC
R
ETIO
N
:M
A
R
G
IN
IM
PR
O
V
EM
EN
T18.61

Estimation using WACC

W
A
C
C
Y
e
a
r
0
Y
e
a
r
1
Y
e
a
r
2
Y
e
a
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3
Y
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4
Y
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a
r
5
E
B
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T
2
.
4
2
9
.
4
8
3
6
.
7
4
3
9
.
7
1
4
1
.
6
9
E
B
I
T
+
1
0
%
T
a
x
@
3
4
%
7
6
3
1
0
0
2
1
2
9
1
5
0
1
7
T
a
x
R
a
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3
4
3
4
.
0
%
E
B
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T
(
1
t
)
1
4
.
8
1
1
9
.
4
6
2
4
.
2
5
2
6
.
2
1
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5
2
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p
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2
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F
3
6
.
3
1
3
2
.
9
6
3
5
.
7
5
3
8
.
7
1
4
0
.
2
W
C
1
2
0
1
0
4
2
0
5
2
0
6
1
0
W
C
+
R
e
d
u
c
t
i
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n

C
A
P
X
.
7
3
.
2
7
.
1
.
5
1
3
.
A
P
X
+
S
a
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C
F
4
6
.
9
1
2
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.
8
6
2
4
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5
2
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0
1
2
1
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0
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rC
T
e
m
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n
a
l
V
a
l
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e
5
0
8
7
F
C
F
G
r
o
w
t
h
5
%
5
.
0
%
F 46.9127.8624.52.01271.9

WACC Calculation

W
A
C
C
C
a
l
c
u
l
a
t
i
o
n
s
S
o
u
r
c
e
o
f
u
n
d
s
D
e
b
t
:
$
A
m
t%
o
f
u
n
d
s
A
f
t
e
r
t
a
x
c
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s
t
W
e
i
g
h
t
e
d
c
o
s
t
R
e
v
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v
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n
g
c
r
e
d
i
t
@
7
.
5
%
$
1
3
4
.
2
0
%
0
.
0
5
0
.
2
1
%
B
a
n
k
d
e
b
t
@
8
.
0
%
8
0
2
6
.
1
0
%
0
.
0
5
3
1
.
3
8
%
S
u
b
o
r
d
i
n
a
t
e
d
d
e
b
t
@
9
.
5
%
1
5
0
4
8
.
9
0
%
0
.
0
6
3
3
.
0
8
%
iT
E
totalyfunds 36
q
u
4
2
0
.
8
0
%
0
.
2
9
5
6
.
1
4
%
0710.0% 10.81%

Where from re = 29.5%?

At D/E = 0 we have ra = 13.5%.

At D/E = 1 we have re = 13.5% + (13.5% - 9.0%) = 18% where 9.0% is

borrowing rate at 50% debt.

At D/E = 4 we have re = 13.5 + 4(13.5% - 9.5%) = 29.5% where 9.5% is

borrowing rate at 80% debt.

NPV using WACC

W
A
C
C
Y
e
a
r
0
Y
e
a
r
1
Y
e
a
r
2
Y
e
a
r
3
Y
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a
r
4
Y
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a
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5
E
B
I
T
2
.
4
2
9
.
4
8
3
6
.
7
4
3
9
.
7
1
4
1
.
6
9
E
B
I
T
+
1
0
%
T
a
x
@
3
4
%
7
6
3
1
0
0
2
1
2
9
1
5
0
1
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T
a
x
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a
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3
4
3
4
.
0
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E
B
I
T
(
1
t
)
1
4
.
8
1
1
9
.
4
6
2
4
.
2
5
2
6
.
2
1
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.
5
2
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p
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i
a
i
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2
5
0
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0
1
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G
i
v
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F
3
6
.
3
1
3
2
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9
6
3
5
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7
5
3
8
.
7
1
4
0
.
2
W
C
1
2
0
1
0
4
2
0
5
2
0
6
1
0
W
C
+
R
e
d
u
c
t
i
o
n

C
A
P
X
.
7
3
.
2
7
.
1
.
5
1
3
.
A
P
X
+
S
a
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e
F
C
F
4
6
.
9
1
2
7
.
8
6
2
4
.
5
2
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1
2
1
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0
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rC
T
e
m
i
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a
l
V
a
l
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e
5
0
8
7
F
C
F
G
r
o
w
t
h
5
%
5
.
0
%
F 46.9127.8624.52.01271.9

Valuing Interest Tax Shield

If the amount of Debt is

constant

Under this financing rule the amount of debt and

hence the interest tax shields stay constant all
through out the year. Considering that you can
carry forward your interest tax shield the risk is
almost the same as your Kd.

If the proportion of debt is constant

If the amount of debt is rebalanced at the
beginning of every year to a fixed proportion of
the value of the project, the future level of the
project shifts up or down depending on the
success or failure of the project. Interest tax
shields therefore take up business risk. Hence,
they should be discounted at Ka.

Miles and Ezzel Adjustment

Miles, J. and Ezzel, R., 1980, The Weighted Average Cost of Capital,
Perfect Capital markets and Project Life: A Clarification, Journal of Financial
and Quantitative Analysis, 15, pp. 719-730.
The value of Interest tax shield found by the second assumption (constant
proportion) would be lesser than the actual value of tax shield because once
you rebalance your debt, the interest tax shield for the next year is known.
Therefore for that one year you should discount @ kd and the rest at Ka.
In other words, Year 1 Interest Tax Shield should be known at the beginning
of the year and hence discount @ Kd. Year 2 ITS will be known at the
beginning of year 2 and hence for one year (between yr1 and yr2) discount
at Kd and for the other year/s (between t=0 and t=1/n-1) discount @ka.

PGP Ltd.
PGP Ltd is planning to build a hydrogen powered
locomotive engine. The investment for the project is
expected to be Rs. 12.5 Mn. and the sales will generate
a pretax Operating annual cash flow of Rs. 2.085 Mn.
Given that PGP Ltd.s Kd= 8%, Ke=14.6% Tc=35% Wd=
50/125 and We=75/125.
(i)Find the NPV of the project.
(ii)Find the APV of the project under two conditions, if
the all equity Ke is 12%:
(a)
(b)
(c)

Fixed amount of debt Rs. 5 Mn.

Fixed proportion of Debt 40% of the firm value.
Find the value using the Miles and Ezzel Adjustment