What is Adjusted Present Value (APV)?

Adjusted Present Value is a valuation method used to calculate the value of a project or company if financed solely by equity and debt. APV takes into consideration the financial benefits of debts, such as interest tax shields, which are deductible interest.  

APV shows investors the benefits of tax shields from tax-deductible interest payments. As a result, APV calculation is the preferred methodology for valuing leverage transactions, such as a leveraged buyout.

The APV formula of unlevered firm value plus net effect of debt is seen as an academic calculation, but is often considered a more accurate valuation compared to other methodologies. According to Harvard Business Review, “APV can help managers analyse not only how much an asset is worth, but also where the value comes from.”

How to calculate Adjusted Present Value (APV)

Step 1: Establishing the base-case cash flows. This is a projection of the target business’s after-tax operating cash flow.

Step 2: Discount cash flow with an appropriate discount rate and terminal value. The discount rate is based on the opportunity cost of capital, which is the expected return from businesses with similar risk profiles if they were financed entirely with equity.

The opportunity costs benchmark for a comparable company with an all-equity capital structure is generally considered to be 13.5%. 

Terminal value for the assets is an estimate of the assets’ value taking into consideration everything after the terminal horizon. For example, if you expect free cash flow for the sixth year, and then for the asset value to grow at 5% per year in perpetuity, the value of the perpetuity is the year-six cash flow divided by the result of the discount rate minus the growth rate.  

Step 3: Evaluate the financing side effects. Interest tax shields are a side-effect of the financing of business, which APV takes into consideration. Interest tax shields arise because of the deductibility of interest payments on the corporate tax return. This contrasts with dividends, which are not deductible.

According to Harvard Business Review, academics agree that tax shields should be discounted at an appropriate risk-adjusted rate, but there is no consensus on the level of riskiness related to tax shields.

Step 4: Initial APV. To calculate an initial estimate of the target’s APV, add the base-case value and the interest tax shields.

Step 5: Customise the analysis to meet different requirements. Managers can further tailor the analysis to their requirements by unbundling the cash-flow projections into separate components such as margin improvements, net-working capital improvements, asset liquidations, and higher steady-state growth. After these components are taxed and discounted, the calculation will show the baseline business value.

An APV example

A multi-year projection for the present value of Company X’s free cash flow plus terminal value is $500,000. Assuming the tax rate for the company is 30% and the interest rate is 7%. Its $50,000 debt load has an interest tax shield of $15,000, or ($50,000*30%*7%)/7%. Based on the above, the APV is $515,000 ($500,000+$15,000).