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WACC versus APV Valuation: Financial Policy and the

Discount Rate
by Antoine Hyafil

Executive Summary
The article uses a simple numerical example to illustrate that:

Weighted average cost of capital (WACC) and adjusted present value (APV) valuation yield identical
results in the (hypothetical) situation when expected cash flows are constant over time;
The equivalence depends crucially on using the right discount rates;
Such discount rates are different when the debt is constant over time, or when it is only expected to be
constant over time;
The equivalence between WACC and APV disappears in the more realistic situation when expected
cash flows are nonconstant, unless the financial structure remains stable;
The formula most often used by practitioners to relate the beta of equity and the beta of the assets of a
corporation is inconsistent with WACC valuation.

Introduction
Franco Modigliani and Merton Millers (1958) Propositions I and II have generated two valuation
methodologies, hereafter referred to as WACC (weighted average cost of capital) and APV (adjusted present
value) valuation. Briefly, Proposition I states that the value of a firm does not depend on its capital structure,
and Proposition II states that a firms value depends on three things: the required rate of return on its assets;
its cost of debt; and its debt/equity ratio. Both valuation methodologies are equivalent provided that the
discount rates are chosen appropriately and consistent assumptions are made regarding the corporations
financial policy. They are not equivalent otherwise, and both may lead to inappropriate valuation if used with
insufficient care.
Modigliani and Millers (MM) Proposition II addresses the relationship between the cost of equity of a levered
firm and the cost of equity of its unlevered equivalent. Whenever financial markets are frictionless, such a
relationship reflects an equilibrium generated by investors arbitrage activities. A consequence is that, in
the absence of market imperfections, neither the value nor the cost of capital of a corporation vary with its
financial structure: the value of the firm is equal to the present value of the free cash flows, discounted at a
constant weighted average cost of capital.
Conversely, as emphasized in many ways by contemporary corporate finance, when imperfections exist a
firms financial structure may impact its valuation. The most familiar imperfection is the tax advantage of debt
implied by the tax deductibility of interest. MM Proposition I shows that the value of a levered firm is equal to
the present value of the free cash flows discounted at the unlevered cost of capital, plus the present value of
the tax savings. This is the basis for APV valuation. WACC valuation remains valid if an adjustment is made
for a world where borrowing has a tax advantage; the value is equal to the present value of the free cash
flows discounted at a weighted average cost of capital, with the latter now incorporating the impact of the tax
shield:
WACC = Cost of debt w(1 # t) + Cost of equity (1 # w)
where w is the ratio, D/EV, of debt to enterprise value, and t is the tax rate.
The WACC and the APV approaches are equivalent to the extent that the return requirements used for
discounting reflect the arbitrage-implied structure of return requirements. However, practitioners using
both methodologies usually arrive at different valuations. This article shows that such differences are the
consequence of different implicit assumptions regarding the firms debt policy, and it attempts to draw
conclusions on the methodological precautions that must be taken. An example will illustrate this.

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Valuation with Constant Free Cash Flows: A Computational Example


Base Case: Debt Level Is Fixed over Time
Consider a company with capital employed (CE) of 270, earnings before interest and taxes (EBIT) of 66, and
beta (u) of the assets = 1.00; initial debt (D), with a beta (d) of 0.3, is set at 77.81, and the tax rate, t, is
1/3. We shall assume that the capital asset pricing model applies, with risk-free rate, Rf, = 5.7% and market
risk premium, Rp, = 6.0%. As a consequence, the required return on assets, COEu, is 11.7%, and the cost
of debt, COD, is 7.5%. (COEu is the cost of unlevered equity, i.e. the return shareholders would require if the
assets were 100% equity financed.)
We shall start by assuming an expected growth rate of 0% and that debt remains constant over time at
77.81.
Table 1 shows that APV valuation yields an enterprise value (EV) of 402.30, and therefore a market value of
equity (MVE) of 323.60. With free cash flows to the firm (FCFFs) discounted at COEu, and tax savings (TS)
discounted at COD, the terminal value of the FCFFs equals FCFF4/COEu and the terminal value of the tax
savings equals TS4/COD. Note that using COD to discount the tax savings does not imply that the latter are
assumed to be riskless, but, as in Modigliani and Millers seminal paper, they are assumed to carry the same
risk as the debt itself.
Table 1. Adjusted present value (APV) valuation
Today

Year 1

Year 2

Year 3

Residual value

Growth

0%

0%

0%

0%

EBIT

66.00

66.00

66.00

66.00

Tax (33%)

22.00

22.00

22.00

22.00

Net operating
profit after tax

44.00

44.00

44.00

44.00

Variation in
capital employed

Free cash flows


to the firm
(FCFF)

44.00

44.00

44.00

44.00

Discount factor
@ COEu
(11.70%)

0.90

0.80

0.72

0.72

DCFF @ COEu

39.39

35.27

31.57

269.84

Market value of
assets

376.07

376.07

376.07

376.07

Debt

78.71

78.71

78.71

78.71

Interest @ COD
(7.50%)

5.90

5.90

5.90

5.90

Tax savings
@ tax rate
(33.33%)

1.97

1.97

1.97

1.97

Discount rate

7.50%

7.50%

7.50%

7.50%

Discount factor

0.93

0.87

0.80

0.80

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Present value of
each annual tax
savings

1.83

1.70

1.58

26.24

26.24

26.24

Enterprise value 402.30


(EV)

402.30

402.30

402.30

Debt

78.71

78.71

78.71

78.71

Market value of
equity (MVE)

323.60

323.60

323.60

323.60

Present value
of all annual tax
savings

26.24

21.12

Table 2. Weighted average cost of capital (WACC) valuation


Today

Year 1

Year 2

Year 3

Residual value

Growth

0%

0%

0%

0%

FCFF

44.00

44.00

44.00

44.00

WACC

10.94%

10.94%

10.94%

10.94%

Discount factor
@ WACC

0.90

0.81

0.73

0.73

DCFF @ WACC

39.66

35.75

32.23

294.66

Enterprise value 402.30


(EV)

402.30

402.30

402.30

Debt

78.71

78.71

78.71

78.71

Market value of
equity (MVE)

323.60

323.60

323.60

323.60

Table 2 shows that WACC valuation yields the same result as APV, with FCFF now discounted at WACC =
10.9370% and residual value at the end of the third year equaling FCFF4/WACC. The WACC computation,
and therefore the equivalence between the two methodologies, depends critically on the cost of equity (COE)
being consistent with the arbitrage-implied structure of return requirements. In the case of debt remaining
constant over time, the classical formulae used by practitioners applies:
COE = Rf + e Rp
and
e = u[1 + (1 t) D/EV]
with computation of D/EV based on the debt of 77.81 and the enterprise value of 402.30 implied by the APV
valuation. The latter formula is the one that prevails in a ModiglianiMiller setting in a world with taxes. In this
case e =1.1135 and COE = 12.3810%.

Modified Case: Debt Varies with the Value of the Assets


Impact on the Discount Rates
Continue to assume an expected growth of 0%, but now replace the assumption that the firm will maintain
a fixed debt level equal to 77.81 over time by the assumption that it will maintain a constant proportion of
debt to enterprise value (D/EV) equal to 20%, whatever the actual deviation from expected growth. The
consequences are as follows:

Tax savings beyond year 1 are now a function of the actual debt levels realized in the future, which
are themselves a function of the actual free cash flows. This implies that tax savings beyond year 1

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have the same probability distribution, and therefore the same risk, as the value of the assets. As a
consequence, from year 2 onwards an APV valuation now needs to discount them at the rate COEu,
which reflects the risk of the assets, rather than at the cost of debt, COD.
Equity is no longer partially protected in a downturn by a fixed level of the tax shield, since the latter
adjusts to the lower value of the assets; it benefits more than before in an upturn, but, given investors
risk-aversion, this does not compensate. As a result, equity holders now require a higher return, COE.
The latter can be derived using the following formulae:

COE = Rf + e Rp
and
e = u(1 + D/EV)
with computation of D/EV based on the target D/EV ratio of 20%. In this case e = 1.1709 and COE =
12.7256%. Note that the formula for the e computation is no longer the same as before but is now identical
to the one which would prevail in a ModiglianiMiller setting in a world without taxes.

Impact on Valuation
Table 3 shows APV valuation. Applying the D/EV target ratio of 20% yields D = 77.81 as before. Enterprise
value (EV ) is 393.54, and market value of equity (MVE) is 314.83, lower than when debt is assumed to
remain constant whatever happens, even though expected debt is assumed to remain constant. FCFFs and
the terminal value of the FCFFs, discounted at COEu, yield the same value as before, but tax savings (TS),
as well as the terminal value of the tax savings (equal to TS4/COEu), are now discounted at COD for one
year only and at COEu thereafter, which yields a lower overall value of the tax savings.
Table 4 shows that WACC valuation yields the same result as APV, with FCFF now discounted at WACC
(11.1805%) higher than before, and a residual value at the end of the third year equaling FCFF4/WACC.
Table 3. Adjusted present value (APV) valuation
Today

Year 1

Year 2

Year 3

Residual value

FCFF

44.00

44.00

44.00

44.00

Discount factor
@ COEu
(11.70%)

0.90

0.80

0.72

0.72

DCFF @ COEu

39.39

35.27

31.57

269.84

Market value of
assets

376.07

376.07

376.07

376.07

Debt

78.71

78.71

78.71

78.71

Interest @ COD
(7.50%)

5.90

5.90

5.90

5.90

Tax savings
@ tax rate
(33.33%)

1.97

1.97

1.97

1.97

Discount rate

7.50%

11.70%

11.70%

11.70%

Discount factor

0.93

0.83

0.75

0.75

Present value of
each annual tax
savings

1.83

1.64

1.47

12.54

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Present value
of all annual tax
savings

17.48

17.48

17.48

17.48

Enterprise value 393.54


(EV)

393.54

393.54

393.54

Debt

78.71

78.71

78.71

78.71

Market value of
equity (MVE)

314.83

314.83

314.83

314.83

Table 4. Weighted average cost of capital (WACC) valuation


Today

Year 1

Year 2

Year 3

Residual value

FCFF

44.00

44.00

44.00

44.00

WACC

11.18%

11.18%

11.18%

11.18%

Discount factor
@ WACC

0.90

0.81

0.73

0.73

DCFF @ WACC

39.58

35.60

32.02

286.36

Enterprise value 393.54


(EV)

393.54

393.54

393.54

Debt

78.71

78.71

78.71

78.71

Market value of
equity (MVE)

314.83

314.83

314.83

314.83

Valuation when Cash Flows Vary over Time


Introducing a non-zero growth rate adds to the complexity: WACC and APV valuation continue to yield the
same outcome under a financial policy of a constant proportion of debt; they do not yield the same outcome
under a policy of a constant level of debt, since such a debt level is now expected to be a variable proportion
of the enterprise value.

If we assume a D/EV of 20%, a 3% perpetual yearly growth of the free cash flows increases debt
capacity from 77.81 to 87.77; both APV and WACC valuations yield an enterprise value (EV) = 438.85.
On the other hand, fixed debt of 77.81 with a 3% growth of the free cash flows yields EV = 451.56 with
WACC valuation, but EV = 456.51 with APV valuation. The latter correctly reflects the evolution of the
financial structure over time, while the former contradictorily assumes that financial structure remains
constant.

Conclusion
Practitioners often compute the equity beta of an unlisted corporation from the asset betas for comparable
listed peers, using the formula which includes tax savings, and then discount the free cash flows at the
cost of capital, thereby making the implicit assumption that the financial structure will remain constant. The
latter assumption is inconsistent with the beta computation. If the financial structure is expected to remain
constant, the beta computation should not incorporate tax savings into the formula. If debt is expected not
to increase with the enterprise value but to remain stable or decrease over time, WACC valuation is not
appropriate.
APV valuation on the other hand will always give the correct value, to the extent that the asset beta has been
computed correctly and tax savings are discounted at the proper rate. In particular, and contrary to popular
belief, using the formula which incorporates the tax shield when applying APV and discounting tax savings
at the cost of debt does not overestimate the value as long as the debt level is expected to remain constant.
In the case of leveraged finance, where debt levels are scheduled to decrease through time, it overestimates
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the beta, and therefore underestimates the value. From a purely methodological point of view, approaches
that apply APV using the levered formula for the asset beta and cost of unlevered equity to discount tax
savings are therefore overly conservative.

Making It Happen

The emphasis in this article on methodological rigor may seem excessive to practitioners, given the
uncertainty about many other parameters; however, in our eyes this does not justify using a wrong
methodology unknowingly.
Practitioners willing to make the methodological effort should be careful in their computation of the
asset beta when using APV in leveraged finance situations.
Computing industry beta by unleveraging peer corporations equity beta first implies assessing,
for each corporation, whether its financial policy is closer to (1) maintaining a stable target debt to
enterprise value ratio or (2) maintaining a stable debt level.
The same applies when computing the asset beta from the firms equity beta prior to a leveraged
recapitalization.
The unlevered beta formula crucially depends on the above assumption, and may therefore vary from
one peer corporation to another.
When industry betas have been carefully computed as above, discount the tax savings at the (pretax)
cost of debt.
Do not forget to take into account the expected costs in case of default to balance the positive
valuation impact of the tax savings.

More Info
Books:

Note that books on this subject usually relate asset beta to equity beta using the formula that
incorporates tax savings. They do not point out that this is only valid when financial structure is
assumed to be constant through time.

Articles:

Harris, R. S., and J. J. Pringle. Risk-adjusted discount ratesExtensions from the average-risk case.
Journal of Financial Research 8 (Fall 1985): 237244.
Miles, James A., and John R. Ezzell. The weighted average cost of capital, perfect capital market and
project life: A clarification. Journal of Financial and Quantitative Analysis 15:3 (September 1980): 719
730. Online at: dx.doi.org/10.2307/2330405
Modigliani, Franco, and Merton H. Miller. The cost of capital, corporation finance and the theory of
investment. American Economic Review 48:3 (June 1958): 261297. Online at: www.jstor.org/stable/
info/1809766

See Also
Checklists

Estimating Enterprise Value with the Weighted Average Cost of Capital

Understanding Capital Structure Theory: Modigliani and Miller

Understanding the Weighted Average Cost of Capital (WACC)


Calculations

Weighted Average Cost of Capital


Finance Library

Valuation: Measuring and Managing the Value of Companies

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