Why should you concern yourself with adjusted present value? Now you probably heard about the present value. In other words, the company’s worth in present day dollars. You create a forecast of business earnings, build up your discount rate, and crunch the numbers. And the discounted cash flow valuation spits our your present value number. Done!
Enter adjusted present value (APV)
But what if you were looking to acquire a company and needed to know what sort of tax benefits this offers? That’s where the adjusted present value (APV) calculation comes in.
Benefits of leveraged buyouts
Seasoned private equity investors often finance such deals with debt. The target company carries little or no debt to begin with.
Let’s say you are considering a leveraged buyout of this firm. You run your net present value calculation and the numbers don’t look quite good enough.
Other people’s money can do the trick
So you could ask: does raising debt offer an additional advantage here? Here is how you can use the APV to figure this out:
- First, determine the all-equity value for this company. In other words, use the equity discount rate and earnings forecast with no debt in the capital structure.
- Next, calculate the additional benefit of debt. This is just the product of your tax rate, interest, the amount you plan to borrow, all divided by the interest.
- Finally, sum up the equity value of the company and the debt financing benefit from above.
The total number you get is the adjusted present value. Depending on your actual situation, this could be higher than the company value alone.
Let’s say you have figured out the debt-free company value at $1,000,000. You also lined up a $500,000 bank loan to close the buyout deal. Your tax rate is 35% and the loan interest is 5%.
Now calculate the debt benefit:
($500,000 x 35% x 5%) / 5% = $175,000
So instead of $1,000,000 you get $1,175,000 of value. This could make a so-so deal into a real winner!
What about the risks of debt financing?
Taking on large amounts of debt is not without risks. If the company is unable to meet its debt repayment obligations, lenders may force it into bankruptcy. You can modify the Adjusted Present Value analysis to account for the risk of financial distress on business value. To do so, you would need to estimate the probability and cost of a potential bankruptcy. This reduces the business value by the appropriate amount.
Are there alternatives to adjusted present value?
The answer is yes. You could just use the regular discounted cash flow valuation. For instance, you capture the effect of both equity and debt by calculating your discount rate as the weighted average cost of capital (WACC). Plus, you should use the net cash flow to total invested capital when doing your earnings forecast.
More than one way to skin the cat.