Adjusted Present Value: An Alternative Method for valuation

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Adjusted Present Value An Alternative Method for
valuation

• Finance 4453

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Traditional DCF (Discount cash Flow)

• The value of a business equals its expected
  future cash flows discounted to present value at
  the weighted average cost of capital (WACC)
• WACC-based standard has severe problems.

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Three Basic Types of Valuation

• Operations
• Existing Assets
• Opportunities
• Future Uncertainties
• Ownership Claims

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NPV(WACC) vs. APV

• WACC is used for the single discount rate which
  is adjusted by financing (tax-adjusted)
• WACC (D/V)(cost of debt)(1-tax rate)
• (E/V)(cost of equity) where V
  Debt Equity
• WACC is suitable only for the simplest and most
  static capital structure needs to be adjusted
  extensively - tax shields, issue costs,
  subsidies, hedges, exotic debt...

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NPV vs. APV

• APV considers two main categories of cash flows
• real cash flows (revenue and operating costs)
  and capital expenditures associated with business
  operation
• side effects associated with its financing
  program

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NPV vs. APV

• APV relies on the principle of value additivity -
  you can break a problem into pieces that make
  managerial sense.
• Executives discover that APV plays to the
  strength of popular spreadsheet software.
• APV handles complexity with lots of subsections
  rather than complicated cell formulas.
• In contrast, WACCs historical advantage was
  precisely that it bundled all the pieces of an
  analysis altogether, so an analyst had to
  discount only once.

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A Case Study

• Ron Henry, president of IBEX Industries,
  considers an acquisition target Acme Filters, a
  division of SL corporation.
• Sources of potential synergies
• Acmes product line will be rationalized to
  improve the operating margin by 3 percentage
  points.
• Resulting in net working capital
• Some assets will be sold.
• Distribution will be streamlined to raise Acmes
  sales growth to 5.
• Taxes will saved through the interest tax shields
  from borrowing.

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APV The Fundamental Idea

• APV Base-case Value Value of all financing
  side effects.
• Where base-case value is value of the project
  as if it were financed with equity alone
• financing side effects include interest tax
  shields, costs of financial distress, subsidies,
  issue costs, etc.

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Some Background

• Acme has not publicly traded shares.
• A few similar public firms become a benchmark for
  estimating the cost of equity. For example, a
  firm without any debt has an estimated cost of
  equity of 13.5
• Evaluate the business as if it were financed
  entirely with equity and then add or subtract
  value associated with financing.

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Step 1 Prepare performance forecasts

• AT operating cash flow is expected to be 36.5M.
• Then consider
• Net working capital
• Capital expenditure
• Other assets
• Free cash flow base-case value

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Step 2 Discount Base-Case Cash-Flows and
Terminal value to Present Value

• How these items are treated is where APV differs
  from other methods.
• Compute the Present Value of the first 5 years
  cash flows using 13.5 as the discount rate.
  E.g., Cost of equity of a comparable firm in
  terms of risk and capital structure (no debt).
• Terminal cash flow estimated using the Gordon
  model 12.5 (15)/ (13.5 - 5)
• Totaling 244.5 M

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Step 3 Evaluate the financing side effects

• Interest tax shields are only considered.
• Henry contemplates on 80 debt financing but
  reduces it to 50 debt.
• In the first year, 21.6 34 7.4 million
• At which rate should we discount these cash flow
  from tax shield? Cost of debt? Uncertain.
• Used 9.5 higher than the average.
• Debt Growth rate at 5, starting in the sixth
  year.

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Step 4 Add the Base-case value and the value of
the interest tax shields.

• APV 244.5M 101.8M 346.3M
• A good deal. Henry would increase his
  shareholders wealth by 39 million (346 307).