The APV Method: Is it Better Than The DCF?

Most valuation analysts are comfort- able using the discounted cash flow (DCF) method of valuation. The DCF method simply discounts cash flows that a business or even a single project is expected to generate, back to the present at a rate of return that is commensurate with the risk of actually receiving the cash flows. The cash flow of an entire business is usually discounted back to the present at the business' weighted average cost of capital (WACC).

Using the discounted cash flow method, however, has limitations. The WACC inherently assumes the capital structure of the business will remain the same in perpetuity. But, what if the capital structure is expected to change? What if you are asked to value a highly leveraged company that is expected to reduce its debt level over time? What if the company has significant net operating loss carryovers? How does a practitioner handle these situations?

Fortunately, a useful methodology in these and many other situations is the Adjusted Present Value Method or the APV. This methodology is becoming increasingly touted by academics as superior to the DCF.'

The APV method has its roots in the initial financial theory proposed by Franco Modigliani and Merton Miller (M&M), who first analyzed the effects of how a firm is financed upon its value.2 The M&M model demonstrated that, under a certain set of assumptions (no taxes or transaction costs), the value of the firm is independent of how it is financed. In other words, under these assumptions, the value of the entire business enterprise doesn't change if the weighting of debt and equity change.

Stewart Myers further expanded the M&M model by developing a model that does not have the restrictive set of assumptions of the M&M theory. Myers developed a model that separates the investment decision and the financing decision in a valuation.3 This model expanded upon the M&M theory by taking into account that interest expense is tax deductible and this tax deductibility may create value. Myers' model has become known as the Adjusted Present Value Model.

AN EASILY UNDERSTOOD MODEL

Conceptually, the APV is relatively easy to understand. The method separates the investment decision from the financing decision by breaking the traditional DCF into two parts. The first part (the investment decision) discounts un-leveraged cash flows to present at an equity rate of return. The second part (the financing decision) discounts the interest tax shield to the present value at a rate of return that reflects the risk in actually achieving these tax benefits. The two parts are then summed to derive the value of the entire enterprise.

The APV is based upon a principle of value additivity that analysts can use with valuations. The APV method is a powerful tool. The method is helpful not only to analysts in indicating the impact different financing alternatives may have on a company's value, but also to managers of businesses in determining the incremental impact of different managerial decisions, such as better working capital management or better asset management on value.4

The traditional DCF analysis accounts for financing effects through the use of the WACC as the discount rate. In calculating a WACC, the after-tax marginal cost of debt is weighted with the cost of equity at a static debt to equity ratio. The debt to equity ratio is usually an assumed "optimal" or "target" level of financing. Any value added through the use of debt financing is considered in the WACC by using the after tax cost of debt. While using a static debt to equity ratio is enticingly simplistic, most company's ratio of debt to equity varies greatly over time. Most company's tax rates change considerably over time, as well.

Fortunately, the APV method can handle situations in which the level of debt to equity is expected to change. Changing level of debt can be cumbersome under the DCF method of valuation, using the WACC. The APV model accomplishes changing debt levels by separating financing effects on value from the value of the operations themselves. Consequently, in situations in which capital structure is expected to change over time, the APV is a more flexible way to estimate value.

THREE STEPS TO A BETTER METHOD

The APV method is a three step process. In the first step, the "real" cash flows to the business (debt free or without and financing effects) are discounted to the present at the equity rate of return. This first step is the value of the operations or the investment decision assuming all equity financing. In the second step, the financing cash flows (the value added by tax shield for type and amount of debt financing of the business) is discounted to present at a risk adjusted rate of return that is commensurate with the risk of receiving the tax benefit of debt financing. In the third step, the two results are summed, which provides a conclusion of value of the entire business.

Why is the APV method better? Rather than using an assumed static debt to equity ratio as in the WACC, the APV method's second step can be used to forecast the tax shield of debt that either increases or decreases over time. In many instances, the changing level of debt represents more accurately what a company expects to happen than does the constant debt to equity ratio assumed in the WACC. Additionally, the APV method can handle the value created through the use of more unusual types of capital structures, such as those with convertible debt and debentures. Finally, since the method is additive, an analyst can reconfigure the model to estimate the impact of specific managerial decisions upon value.

A CASE IN POINT

Ted Carter, president of Peachtree Electronics, has asked you to estimate the value of his company. Carter has received an indication of interest from Big Electronics to acquire 0 of Peachtree's equity. As such, Carter would like you to assist him in understanding the fair market value of Peachtree.

What if we estimated the value of Peachtree using traditional discount cash flow method? How does discounting debt free cash flows at the WACC compare to the value indicated under the APV method? Table 6 shows the same cash flows of Peachtree discounted to present value at the WACC of Peachtree, which is calculated to be 17%, as shown in Table 6. We assumed that the 'target" capital structure for Peachtree in our calculation of its WACC to be 70% equity and 30% debt.' The present value of the projected debt free cash flows of Peachtree discounted at the WACC is $5,511,000 (Table 6). There is almost $500,000 difference in the indicated value between both methods. Why would this be the case? Well, recall that Peachtree is reducing its level of debt from the first year of the projections to a more normal level. The difference in value is due to the higher level of tax shield reflected in the APV method as opposed to the DCF. Since management expects the level of debt to change over time, the APV method provides a better indication of the value of the equity of Peachtree, particularly for this purpose of valuation. As you can see in this example, the traditional discounted cash flow using the WACC with a static debt to equity ratio missed some of the value created through the way the business is actually financed.

SUMMING UP

The traditional discounted cash flow method wherein debt free cash flows are discounted to the present at the WACC may not be appropriate in every circumstance, The WACC assumes a static debt to equity ratio presumably at an optimal capital structure. However, many companies do not expect to have a static level of debt to equity, particularly in situations involving highly leveraged transactions. Under these types of situations, the Adjusted Present Value Method may be a better method. The APV separates the value of operations from value created or destroyed by how the company is financed. The APV may be a better tool to analyze the value of entities with unique financing because it separates the value of the operations of a business purely from the value that is created through the way the business is financed. As such, the APV can also be used as a management tool to break out the value created from specific managerial decisions.