Adjusted present value (APV) valuation

Description
The Adjusted Present Value (APV) model is a valuation method that separates the value of operations into two components: the value of operations if the company were all-equity financed (unlevered value of operations) and the value of tax shields. If applied properly, the APV model should yield the same result as the WACC-based models.


The model assumes that the risk of tax shield mirrors the risk of operating assets, therefore Betatxa = Bu, debt is risky, and the level of debt fluctuates. The APV model is not widely used when valuing companies that have a zero or minimal probability of default on their debt. It is more common in distressed situations or when it is expected that a company will significantly alter its capital structure. However, I find it helpful as a reminder of what drives change in value.


As you will see in the model, as you increase the stock of debt, Enterprise Value increases. If that were the case in real life, why not finance 100% of operations with debt? The reason is the potential bankruptcy or default costs. Companies try to keep the level of debt up to an optimal level, which differs from industry to industry and is generally higher in industries with low volatility of cash flows.
If a company is overlevered, i.e., it breaches its optimal debt level, customers might become reluctant to do business with the company causing revenues to decrease, suppliers might require upfront payments for deliveries causing working capital needs to increase, and the company might have to postpone investments, thereby jeopardizing future growth. All of this will decrease future free cash flow and the Enterprise Value. With decreasing revenue, the company might not have enough taxable income to utilize 100% of interest tax shields, and the value of tax shields will decrease, bringing Enterprise Value further down.
Therefore, as you change the level of debt in the model, make sure to revisit your operating projections. If the company's debt is trading at a significant discount due to the default risk, and your DCF is showing Enterprise Value significantly above the market value of debt, something is probably not right, or at least the market is disagreeing with you.


Note that I have built this model for an investment-grade company. The company was significantly impacted by the COVID pandemic and completed a large debt-funded acquisition just before the pandemic. The current debt stock in the capital structure is somewhat above the optimal level that the company targets. In my projections, I assumed that the operating performance is not affected by the current level of debt. However, if another crisis were to occur, causing the company to further increase its debt, I would revisit my assumptions.


This model aims to demonstrate the mechanics of the APV method. I have provided simplified projections and assumptions. A version of this model is part of a larger valuation model. In practice, changing one assumption is likely to affect other assumptions. For example, if you change the EBITA margin, the reinvestment rate would probably change as well.