What is the benefit of doing Step 5 of the Adjusted Present Value process? What are some potential problems that could be involved with this type of value decomposition?
Step 1: Find unlevered free cash flows (called base-case in the article). Prepare pro forma statements as before. You will have a planning period and a terminal value. FCF is calculated the same way as in DCF. Step 1 is no different from how we begin a DCF analysis.
Step 2: Find the present value of the base-case cash flows and sum. What discount rate do we use? Discount rates must be consistent with the cash flows on which they are used! For the unlevered free cash flows: We are making the assumption that the firm is all equity, so we should use a cost of equity—but which one? We are also making the assumption that the firm has no debt, so we should use a cost of equity based on the unlevered beta (which measures the firm's risk assuming it has no debt)! Use this kunlevered to calculate: The terminal value. The present values of the planning period cash flows and of the terminal value. Equity cash flows must be discounted by an equity cost of capital (and unlevered cash flows by an unlevered cost of capital). Debt cash flows must be discounted by a debt cost of capital. Firm cash flows must be discounted by a firm cost of capital (which will not apply to the APV approach). We always have to use risk-appropriate discount rates!
Step 3: Calculate the cash flows from the financing side effects, i.e., the interest tax shield, and find the present value. We make the assumption that interest is paid based on the principal at the beginning of the year. So, to calculate the tax shield from year t, we use the amount of debt outstanding from the end of year (t-1). You will have a planning period and a terminal value. Tax shieldt = amount of debtt-1 × cost of debt × tax rate. What discount rate do we use? For the interest tax shield: There is some debate on how risky these cash flows are. A common assumption is that they have the same risk level as debt, and so the cost of debt is often used as the discount rate. That is what we will do in this class unless you can make a good case for using something else. Use this discount rate to calculate: The terminal value for the interest tax shield. The present value of the planning period interest tax savings and of the terminal value of the tax shield.
Step 4: Add together the present values of your unlevered free cash flows (step 2) and your interest tax shield (step 3). So far, you have basically conducted two mini-discounted-cash-flow-type analyses: one for the equity portion of the firm and the other for the debt portion of the firm. Since the value of the firm is the value from both the equity and debt financed portions, the next step is to add both of these values together. The result is the enterprise value of the firm. To obtain equity value, proceed as you did in the WACC method: EV = Equity value + Net Debt Net Debt = Interest-bearing Liabilities – Cash Step 5: Take the Analysis Further!
Step 5 is optional, in that you have already calculated the value of the firm. By doing an APV analysis, you have already decomposed firm value into two parts: the equity-financed portion and the debt-financed portion. Step 5 shows that you can do an even more detailed decomposition if you wish—you can do a separate valuation for the as-is firm (the debt and equity portions), and also a valuation for each projected synergy individually (each synergy may also have debt and equity portions, but more commonly will just be equity). One of the benefits of APV is that you can break down the sources of value to see how each contributes to the overall value of the firm. In the context of M&A, this means you can evaluate each synergy separately to see its contribution. You essentially do a mini-DCF analysis for each synergy, using the unlevered cost of equity as the discount rate.