What is an 'Adjusted Present Value - APV'
The adjusted present value is the net present value (NPV) of a project or company if financed solely by equity plus the present value (PV) of any financing benefits, which are the additional effects of debt. By taking into account financing benefits, APV includes tax shields such as those provided by deductible interest.
BREAKING DOWN 'Adjusted Present Value - APV'To calculate the adjusted present value is to first calculate the NPV of the project or company without debt. Then, the NPV is adjusted to include the benefits of financing. Main benefits of this approach are often tax shields resulting from one or more tax deductions of interest payments or a subsidized loan at below-market rates. Leveraged buyout situations are the most effective situations in which to use the adjusted present value methodology.
Calculating Adjusted Present Value
While the adjusted present value method is similar to the discounted cash flow methodology, adjusted present cash flow does not capture taxes or other financing effects in a weighted average cost of capital (WACC) or other adjusted discount rate. Unlike WACC used in discounted cash flow, adjusted present value seeks to value the effects of the cost of equity and cost of debt separately. In essence, the adjusted present value equals:
Adjusted Present Value = Base-case net present value + net present value of all financing side effects
In practice, the adjusted present value is not used as much as the discounted cash flow method. It is more of an academic calculation but is often considered to result in more accurate valuations.
Along with the initial NPV estimate, three other variables must be calculated. The first, which is widely considered the most important side effect of financing, is the interest tax shield (ITS). The ITS is created when companies have debt because the interest on the debt is tax-deductible. The ITS is calculated as:
ITS = Interest Expense x Tax Rate
The next component is the ITS Used. Because not all of the ITS must be used in a given year and can be carried forward, the ITS Used is calculated as:
ITS Used = minimum(ITS, taxes)
Lastly, the terminal value (TV) of the ITS is calculated. The formula for this is TV ITS = t x Debt x Re x (1 + g) / (Re - g) ^ 2, where
t = tax rate
Debt = terminal year debt balance
Re = required return on equity
g = terminal growth rate
In a financial projection where a base-case NPV is calculated, the sum of the present value of the ITS Used and the TV ITS are added to obtain the adjusted present value. For example, assume a multi-year projection calculation finds the present value of a firm's free cash flow plus terminal value is $230,700. If the present value of the ITS Used is $10,000 and present value of the TV ITS is $6,000, then the adjusted present value is:
Adjusted Present Value = $230,700 + $10,000 + 6,000 = $246,700