Valuation - APV / Financial Distress Cost

1.  Valuation Using APV

APV is the net present value of a project if financed solely by ownership equity plus the present value of all the benefits of financing. The method is to calculate the NPV of the project as if it is all-equity financed (so called base case). Then the base-case NPV is adjusted for the benefits of financing. Usually, the main benefit is a tax shield resulted from tax deductibility of interest payments. Another benefit can be a subsidized borrowing at sub-market rates. The APV method is especially effective when a leveraged buyout case is considered since the company is loaded with an extreme amount of debt, so the tax shield is substantial. Technically, an APV valuation model looks similar to a standard DCF model. However, instead of WACC, cash flows would be discounted at the unlevered cost of equity, and tax shields at either the cost of debt or following later academics also with the unlevered cost of equity.

2.  When is APV better than DCF model?

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.

3. Financial Distress Cost

Financial distress costs are costs associated with companies who cannot meet its financial obligations. Financially distressed companies incur more costs as their cost of borrowing is higher, their production is lesser and they have higher opportunity costs in terms of lost income. Also included are reorganization or liquidation costs. A company under financial distress can incur costs related to the situation, such as more expensive financing, opportunity costs of projects and less productive employees. The firm's cost of borrowing additional capital will usually increase, making it more difficult and expensive to raise the much needed funds. In an effort to satisfy short-term obligations, management might pass on profitable longer-term projects. Employees of a distressed firm usually have lower morale and higher stress caused by the increased chance of bankruptcy, which would force them out of their jobs. Such workers can be less productive when under such a burden.

4. Points to Ponder

1)      Will APV and DCF give the same result if the capital structure remains constant?

Courtesy: Tanmay Ravi, PGP-IIMA