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web extension 23A

The Adjusted Present


Value (APV) Approach
The corporate valuation or residual equity methods described in Chapter 23 both work well
when a company keeps a constant capital structure. However, in many situations, there
will be a nonconstant capital structure in years immediately following the merger. For
example, this often occurs if an acquisition is financed with a temporarily high level of debt
that will be reduced to a sustainable level as the merger is digested. In such situations it is
extremely difficult to correctly apply the corporate valuation model or the equity residual
model because the cost of equity and the cost of capital are changing as the capital structure
changes. Fortunately, the adjusted present value model is ideally suited for such situations,
as we show below.
Recall from Chapter 12 that interest payments are tax deductible. This means that the
government receives less tax revenue from a levered firm than from an otherwise identical
but unlevered firm, which leaves more money available for the levered firms investors.
More money for investors increases a firms value, all else equal. In other words, the value
of a levered firm is equal to the value of an unlevered firm plus an adjustment for tax sav-
ings. The adjusted present value (APV) approach explicitly employs this concept by expressing
the value of operations as the sum of two components: (1) the unlevered value of the firms
operations (i.e., as though the firm had no debt), plus (2) the present value of the interest tax
savings, also known as the interest tax shield:

VOperations 5 VUnlevered 1 VTax shield (23A-1)

The value of an unlevered firms operations is the present value of the firms free cash flows
discounted at the unlevered cost of equity, and the value of the tax shield is the present value
of all of the interest tax savings (TS), discounted at the unlevered cost of equity rsU:1

VUnlevered 5 a
` FCFt
 (23A-2)
1
t51 1 1 rsU
2t

and

VTax shield 5 a
` TSt
 (23A-3)
1
t51 1 1 rsU
2t

To apply Equations 23A-2 and 23A-3, the FCF and TS must eventually stabilize at a
constant growth rate. When they do so, we can use an approach similar to the ones we used
for the nonconstant dividend model in Chapter 8 and the corporate valuation model in
Chapter 22. In those approaches, we explicitly projected the years with nonconstant growth
rates, found the horizon value at the end of the nonconstant growth period, and then calcu-
lated the present value of the horizon value and the cash flows during the forecast period.

1Although some analysts discount the tax shield at the cost of debt or some other rate, we believe that the unlevered cost

of equity is the appropriate discount rate for the interest tax savings. See Chapter 12 for a detailed explanation.

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23A-2 Web Extension 23A The Adjusted Present Value (APV) Approach

Here is a description of how to apply that approach in the APV model.

1. Calculate the targets unlevered cost of equity, rsU, based upon its current capital struc-
ture at the time of the acquisition. In other words, you unlever the targets cost of
equity. From Chapter 12, Equation 12-6 expresses a firms levered cost of equity, rsL, as
a function of its unlevered cost of equity, its cost of debt (rd), and the amount of debt (D)
and equity (S) in its capital structure:

rsL 5 rsU 1 1rsU 2 rd2 1D/S2 (23A-4)

Because the weights of debt and equity in a capital structure, wd and ws, are defined
as D/(D 1 S) and S/(D 1 S), the ratio of D/S can be expressed as wd/ws. We make this
substitution in Equation 23A-4 and solve for the unlevered cost of equity:

rsU 5 wsrsL 1 wdrd (23A-5)

Keep in mind that rsL, rd, wd, and ws are based upon the targets capital structure imme-
diately before the acquisition.
2. Project the free cash flows, FCFt, and the annual interest tax savings, TSt. The tax savings
are equal to the projected interest payments multiplied by the tax rate:2

Tax savings 5 1Interest expense2 1Tax rate2 (23A-6)

You must project enough years so that the FCF and the tax savings are expected
to grow at a constant rate (g) after the horizon, which is at Year N. This means that
the capital structure must become constant at Year N 2 1 to ensure that the projected
interest payment at year N will grow at a constant rate after year N. Later in this Web
Extension we provide a detailed explanation of how to project financial statements that
reflect a constant capital structure. For the remainder of this, we will assume that your
trusty assistant has made such projections.
Notice that the APV approach does not require a constant capital structure in each
and every year of the analysis, only that the capital structure must eventually become
stable in the post-horizon period.
3. Calculate the horizon value of an unlevered firm at Year N (HVU,N), which is the value
of all free cash flows beyond the horizon discounted back to the horizon at the unlev-
ered cost of equity. Also calculate the horizon value of the tax shield at Year N (HVTS,N),
which is the value of all tax shields beyond the horizon discounted back to the horizon
at the unlevered cost of equity. Because FCF and TS are growing at a constant rate of g
in the post-horizon period, we can use the constant growth formula:

Horizon value of FCFN11 FCFN 11 1 g2


5 r 2g 5 rsU 2 g (23A-7)
unlevered firm 1HVU,N2 sU

and

Horizon value of TSN11 TSN 11 1 g2


5r 2g5 r 2g (23A-8)
tax shield 1HVTS,N2 sU sU

The unlevered horizon value is the horizon value of the company if it had no debt.
The tax shield horizon value is the contribution the tax savings after year N make to the

2The tax shield is based only on interest expense, not the net value of interest expense and interest income. This is because the

impact of interest income is taken into account when the value of short-term investments is added later to the value of opera-
tions. Including the impact of interest income in the tax shield would be double counting. In other words, there are no side
effects due to owning a short-term investment: The value of the investment to the company is just the reported value. This is in
contrast to debt, which does have a side effect in the sense that the cost to the company is less than the reported value due
to the tax shield provided by the debt.

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The Adjusted Present Value (APV) Approach 23A-3

horizon value of the levered firm. Therefore the horizon value of the levered firm is the
sum of the unlevered horizon value and the tax shield horizon value.
4. Calculate the present value of the free cash flows and their horizon value. This is the
value of operations for the unlevered firm, that is, the value it would have if it had
no debt. Also calculate the present value of the yearly tax savings during the forecast
period and the horizon value of tax savings. This is the value that the interest tax shield
contributes to the firm. The sum of the value of unlevered operation and the value of the
tax shield is equal to the value of operations for the levered firm.

VUnlevered 5 a
N FCFt HVU,N
t
1 (23A-9)
1
t51 1 1 rsU
2 11 1 rsU2 N

VTax shield 5 a
N TSt HVTS,N
1 (23A-10)
1
t51 1 1 rsU
2t 11 1 rsU2 N

VOperations 5 VUnlevered 1 VTax shield (23A-11)

5. To find the total value of the firm, add the value of operations to the value of any non-
operating assets, such as marketable securities. To find the value of equity, subtract the
value of the debt before the merger from the total value of the firm.

Unlevered value of operations


1Value of tax shield
Value of operations
1Value of nonoperating assets
Total value of firm
2Value of debt
Value of equity

To find the stock price per share, divide the value of equity by the number of shares.

The APV technique is especially useful in valuing acquisition targets. Many acquisi-
tions are difficult to value using the corporate valuation model because (1) acquiring firms
frequently assume the debt of the target firm, so old debt at different coupon rates is often
part of the deal, and (2) the acquisition is usually financed partially by new debt that will
be paid down rapidly, so the proportion of debt in the capital structure changes during the
years immediately following the acquisition. Thus, the debt cost and capital structure asso-
ciated with a merger are generally more complex than for a typical firm. The easiest way
to handle these complexities is to specify each years expected interest expense and use the
APV method to find the value of the unlevered firm and the interest tax shields separately,
and then sum those values.

Illustration of Valuation Using the APV Approach


Using the Tutwiler illustration in Chapter 23, the APV approach requires an estimate of
Tutwilers unlevered cost of equity. Inputting Tutwilers capital structure, cost of equity, and
cost of debt, Equation 23A-5 can be used to estimate the unlevered cost of equity:

rsU 5 wsrsL 1 wdrd (23A-5)

5 0.6983 113%2 1 0.3017 19%2


5 11.793%

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23A-4 Web Extension 23A The Adjusted Present Value (APV) Approach

In other words, if Tutwiler had no debt, its cost of equity would be 11.793%.
The horizon value of Tutwilers unlevered cash flows (HVUL,2019) and tax shield
(HVTS,2019) can be calculated using the constant growth formula with the unlevered cost of
equity as the discount rate:3

FCF2020 FCF2019 11 1 g2 $6,800 11.062


HVU,2019 5 5 5 5 $124.4 million
1rsU 2 g2 1rsU 2 g2 0.11793 2 0.06

TS2020 TS2019 11 1 g2 $1.57 11.062


HVTS,2019 5 5 5 5 $28.7 million
1rsU 2 g2 1rsU 2 g2 0.11793 2 0.06
The sum of the two horizon values is the horizon value of operations, $153.1 million,
which is the same as the horizon value calculation we reached with the corporate valuation
model.
Row 11 in Table 23-3 shows the projected free cash flows. The unlevered value of opera-
tions is calculated as the present value of the free cash flows during the forecast period and
the horizon value of the free cash flows:

$3.2 $3.2 $5.6


VUnlevered 5 1 1
11 1 0.117932 11 1 0.117932 2 11 1 0.117932 3
$6.4 $6.8 1 $124.4
1 4
1
11 1 0.117932 11 1 0.117932 5
5 $88.7 million

This shows that Tutwilers operations would be worth $88.7 million if it had no debt.
Next, the yearly interest tax shields are calculated. Row 6 in Table 23-3 shows yearly
interest expense. Given the tax rate of 40%, the interest tax shield for 2015 is $3.0 3 0.40 5
$1.2. Below are all the yearly interest tax shields.

2015 2016 2017 2018 2019


Interest tax savings 5 Interest (T) $1.2 $1.3 $1.4 $1.5 $1.57

The value of the tax shield is calculated as the present value of the yearly tax savings and
the horizon value of the tax shield:

$1.2 $1.3 $1.4


VTax shield 5 1 1
11 1 0.117932 11 1 0.117932 2 11 1 0.117932 3

$1.5 $1.57 1 $28.7


1 4
1
11 1 0.117932 11 1 0.117932 5

5 $21.4 million

Thus, Tutwilers operations would be worth only $88.7 million if it had no debt, but its
capital structure contributes $21.4 million in value due to the tax deductibility of its interest
payments. Since Tutwiler has no nonoperating assets, the total value of the firm is the sum
of the unlevered value of operations, $88.7 million, and the value of the tax shield, $21.4 mil-
lion, for a total of $110.1 million. The value of the equity is this total value less Tutwilers out-
standing debt of $27 million: $110.1 2 $27 5 $83.1 million. This is also the value we obtained
using the corporate valuation model.
Table 23A-1 summarizes all three cash flow valuation methods and their assumptions.

3Note that we report two decimal places for the 2019 tax shield even though Table 23-3 reports only one decimal place.

All calculations are performed in Excel, which uses the full nonrounded values.

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Projecting Consistent Debt and Interest Expenses 23A-5

TABLE
23A-1 Summary of Cash Flow Approaches

Approach
Corporate Valuation Free Cash Flow to Equity
Model Model APV Model
Cash flow FCF 5 NOPAT 2 FCFE 5 FCF 2 Interest (1) FCF
definition: Net investment in expense 1 Interest tax shield (2) Interest tax savings
operating capital 1 Net change in debt
Discount rate: WACC rsL 5 Cost of equity rsU 5 Unlevered cost
of equity
Result of present Value of operations Value of equity due to (1) Value of unlevered
value operations operations
calculation: (2) Value of the tax shield.
Together, these are the
value of operations.
How to get Value of operations 1 Value of equity due to Value of operations 1
equity value: Value of nonoperating operations 1 Value of Value of nonoperating
assets 2 Value of debt nonoperating assets assets 2 Value of debt
Assumption Capital structure is Capital structure is None
about capital constant. constant.
structure during
forecast period:
Requirement for No interest expense Projected interest expense Interest expense
analyst to projections needed must be based on the projections are
project interest assumed capital structure. unconstrained.
expense:
Assumption at FCF grows at constant FCFE grows at constant FCF and interest tax savings
horizon: rate g. rate g. grow at constant rate g.

Projecting Consistent Debt and Interest


Expenses See Ch 23 Tool Kit.xlsx at
the textbooks website for
Projecting financial statements for a merger analysis requires explicit assumptions regarding all calculations.
the capital structure in the postmerger years. This section shows how to project debt and
interest expenses that are consistent with the capital structure assumptions. Refer to the
worksheet Web 23A in the file Ch 23 Tool Kit.xlsx for all calculations.

Projecting Consistent Debt and Interest Expenses


When Capital Structure Is Constant
Recall that the FCFE model and the APV model (explained earlier in this Web Extension)
both require a projection of interest expense. If the projected interest expense is not con-
sistent with the assumed constant capital structure, then the APV and FCFE models will
produce incorrect answers. This section will show how the debt levels and interest expenses
in Table 23-3 in the text were constructed in a manner consistent with the assumed constant
capital structure. Keep in mind, though, that if the capital structure is assumed to be con-
stant, then it is always easier to use the corporate valuation model rather than either the APV
model or the FCFE model.
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23A-6 Web Extension 23A The Adjusted Present Value (APV) Approach

TABLE Constant Capital Structure: The Value of Operations, Debt, and Interest Expense
23A-2 (Millions of Dollars)

1/1/15 12/31/15 12/31/16 12/31/17 12/31/18 12/31/19


FCF $ 3.2 $ 3.2 $ 5.6 $ 6.4 $ 6.8
Horizon value 153.1
Value of operations $110.1 118.7 128.2 136.3 144.5 153.1
Value of debta 33.2 35.8 38.7 41.1 43.6 46.2
Interest expenseb 3.0 3.2 3.5 3.7 3.9

aDebt 5 wd(Vop ).
bThe interest expense is based on the amount of debt at the beginning of the year: Interest expense in Year t 5 rd(Debtt-1).

Here are the steps required to project debt levels that are consistent with the assumed
constant capital structure:

1. Use the techniques of Chapter 5 to project the operating items on the financial state-
ments needed to calculate free cash flows. Notice that these projections dont depend on
the capital structure because they are for operating items and not financial items.
2. Calculate the WACC that corresponds to the constant capital structure.
3. Calculate the horizon value of operations using the corporate valuation model horizon
value formula.
4. Calculate the value of operations in each year of the projections as the present value of
the next years value of operations and the next years free cash flows.
5. Calculate the projected debt level by multiplying the value of operations by the per-
centage of debt in the assumed constant capital structure. The projected interest expense
in any year is the projected interest rate multiplied by the projected amount of debt at
the beginning of the year.

Step 1. Project Operating Items The worksheet Web 23A in the file Ch 23 Tool Kit.xlsx
shows the projected financial statement items related to Tutwiler Controls operations and its
projected free cash flows. The free cash flows are shown here in the first row of Table 23A-2.
The following sections explain the other rows of Table 23A-2.
Step 2. WACC Calculation This is the same calculation we performed in Chapter 23.
Tutwiler will maintain its current capital structure consisting of 30.17% debt and 69.83%
equity. Tutwilers cost of equity was calculated to be 13%, and its cost of debt is 9%. Tutwilers
tax rate is 40%, so its WACC is

WACC 5 wd 11 2 T2 rd 1 wsrs

5 0.3017 11 2 0.402 19%2 1 0.6983 113%2 5 10.707%

Step 3. Horizon Value of Operations Tutwilers free cash flow in 2019, FCF2019, was pro-
jected to be $6.8 million with an expected growth rate of 6%. In Chapter 23, we calculated the
horizon value, HV2019, to be
FCF2019 11 1 g2 $6.8 11.062
HV2019 5 5 5 $153.1 million
WACC 2 g 0.10707 2 0.06
This horizon value is shown in the second row of Table 23A-2.
Step 4. Calculate the Value of Operations Each Year Tutwilers value of operations at the
end of 2019 is simply the horizon value of operations, $153.1 million. The value of opera-
tions at the end of 2018 is the present value of all of the cash flows to be received after 2018,
discounted back to 2018. This is equal to the present value of the value of operations in 2019
plus the 2019 free cash flow, discounted back 1 year:

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Projecting Consistent Debt and Interest Expenses 23A-7

Vop 2019 1 FCF2019 $153.1 1 $6.8


Vop 2018 5 5 5 $144.5 million
1 1 WACC 1 1 0.10707

Similarly,

Vop 2018 1 FCF2018 $144.5 1 $6.4


Vop 2017 5 5 5 $136.3 million
1 1 WACC 1 1 0.10707

The value of operations for each year is shown in the third row of Table 23A-2.
Step 5. Calculate the Amount of Debt Each Year We assumed that Tutwilers capital
structure will remain constant each year, with debt set at 30.17% of the value of opera-
tions. Thus in 2019 debt will be $153.1(0.3017) 5 $46.2 million, and in 2018 debt will be
$144.5(0.3017) 5 $43.6 million. Interest expense is equal to the debt level at the start of the
year, which is the debt level at the end of the previous year, multiplied by the interest rate
on debt. The interest rate on debt is 9%, so in 2019 interest expense is $43.6(0.09) 5 $3.9 mil-
lion. The interest expenses for 2015 through 2018 are calculated similarly and are shown in
Table 23A-2.
The debt level in 2014 and the interest expense in 2015 deserve comment. In 2014, prior to
the merger, Tutwiler has $27 million in debt, and this comprises 30.17% of its capital structure
based on its premerger value. However, if the merger goes through, then Tutwilers value will
increase because of synergies with Caldwell, and, to maintain the assumed 30.17% of debt,
Tutwiler will immediately issue an additional $6.2 million in debt, for a total of $27.0 1 $6.2
5 $33.2 million in debt outstanding. This additional $6.2 million in debt will be in Tutwilers
capital structure by the start of 2015 and will therefore contribute to its interest expense in 2015.
Thus, Tutwilers projected 2015 interest expense is $33.2(0.09) 5 $3.0 million. Debt levels are
shown in the fourth row of Table 23A-2.

Projecting Consistent Debt and Interest Expenses


When Capital Structure Is Nonconstant
In some situations, the capital structure is assumed to change during the forecast period prior
to becoming constant at the horizon. Neither the corporate valuation model nor the FCFE
model is appropriate because the discount rates vary during the forecast period. The APV is
the appropriate approach, but it is necessary to project the interest expense at the horizon in a
manner that is consistent with the assumed post-horizon constant capital structure.
In this section we show how the interest expense at the horizon is calculated for the case
in which Tutwilers capital structure changes during the forecast period before becoming
constant at the end of the horizon. To ensure correct calculations of the horizon value of the
unlevered firm and the horizon value of the tax shield, the company must be at its long-term
constant capital structure in the last year of projections, in this case 2019. This means the debt
level at the end of 2018 must be consistent with the assumed long-term capital structure so
that the interest expense in 2019 is also consistent with the long-term capital structure. The
steps to project a consistent debt level for 2018 are similar to those described in the previous
section:

1. Use the techniques of Chapter 5 to project the operating items on the financial state-
ments needed to calculate free cash flows. Notice that these projections dont depend on
the capital structure because they are for operating items and not financial items.
2. Calculate the levered cost of equity and WACC that will prevail in the post-horizon
period when the capital structure has become constant.
3. Calculate the horizon value of operations using the corporate valuation model horizon
value formula.
4. Calculate the value of operations in the last 2 years of the forecast period.
5. Calculate the projected debt level by multiplying the value of operations by the percent
of debt in the assumed constant capital structure.

In this example, Tutwiler will have a varying amount of debt until the end of 2018, at which
point its debt level must be consistent with a long-term capital structure consisting of 50%
debt. The results of these calculations appear in Table 23A-3.
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23A-8 Web Extension 23A The Adjusted Present Value (APV) Approach

TABLE Nonconstant Capital Structure during Forecast Period: The Value of


23A-3 Operations, Debt, and Interest Expense at the End of the Forecast Period
(Millions of Dollars)

2015 2016 2017 2018 2019


FCF $3.2 $3.2 $5.6 $ 6.4 $ 6.8
Horizon value 185.1
Value of operations 174.6 185.1
Value of debt 87.3
Interest expense 8.3

Step 1. Project Operating Items The worksheet Web 23A in the file Ch 23 Tool Kit.xlsx
shows the projected financial statement items related to Tutwilers operations and its pro-
jected free cash flows. The free cash flows are shown here in the first row of Table 23A-3. The
following sections explain the other rows of Table 23A-3.
Step 2. Calculate the Unlevered Cost of Equity and WACC at Post-Horizon Target
Capital Structure Earlier in this Web Extension we calculated Tutwilers unlevered cost of
equity based on the pre-merger capital structure and pre-merger costs of debt and equity:

rsU 5 wsrsL 1 wdrd

5 0.6983 113%2 1 0.3017 19%2 5 11.793%

Under the proposed 50% debt capital structure for the post-horizon period, the interest rate
on the debt will increase to 9.5%. The cost of equity, rsL, will also increase due to the increased
leverage. This post-horizon cost of equity can be calculated with Equation 23A-3, using the
post-horizon capital structure cost of debt:

rsL 5 rsU 1 1rsU 2 rd2 1D/S2

5 11.793% 1 111.793% 2 9.5%2 10.50/0.502 5 14.086%

The new WACC can then be calculated from this new rsL and rd:

WACC 5 wd 11 2 T2 rd 1 wsrsL

5 0.50 11 2 0.402 19.5%2 1 0.50 114.086%2 5 9.893%

This is the WACC that should persist at the horizon and thereafter.
Step 3. Calculate the Horizon Value of Operations The horizon value of operations at the
new WACC is

FCF2019 11 1 g2
HV2019 5
WACC 2 g
$6.8 11.062
5 5 $185.1
0.09893 2 0.06

This value is shown in the second row of Table 23A-3.


Step 4. Calculate the Value of Operations in the Last Year and the Prior Year The value of
operations at the end of 2019 is simply the horizon value, $185.1 million. The value of opera-
tions at the end of 2018 is the present value of the value of operations in 2019 and the free
cash flow in 2019:

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Projecting Consistent Debt and Interest Expenses 23A-9

Vop 2019 1 FCF2019


Vop 2018 5
1 1 WACC
$185.1 1 $6.8
5 5 $174.6 million
1 1 0.09893

The values of operations for 2018 and 2019 are shown in the third row of Table 23A-3.
Step 5. Calculate the Debt Level in the Year Prior to the End of the Horizon The debt level
in 2018 is now easy to calculate. It is the post-horizon target percentage of debt multiplied by
the value of operations in 2018:

Debt2018 5 0.50 1$174.62 5 $87.3 million

and the interest in 2019 is simply the debt at the end of 2018 multiplied by the interest rate:

Interest2019 5 $87.3 19.5%2 5 $8.3 million

This is the interest used to calculate the horizon value of the interest tax shield in the text.
The debt levels and interest tax shields during the prior years need not conform to a con-
stant capital structure. As long as the interest expense in the last projected year is expected
to grow at a constant rate, which our calculations guarantee, the APV approach may be
applied.
There is a shortcut when calculating the APV if you dont need to know the separate
values of the unlevered firm and the value of its tax shields. First, use the corporate valuation
models horizon value calculation to calculate the horizon value based on the WACC that
will persist in the long term and the last years projected free cash flows. Second, calculate
the interest tax shields that will result from the assumed debt levels prior to the horizon.
These assumed debt levels prior to the horizon need not be consistent with any particular
long-term debt policy. Third, add the interest tax shields, the horizon value, and the free
cash flows together for each year. Fourth, discount these cash flows at the unlevered cost of
equity.
For example, Table 23A-4 shows the free cash flows from Table 23A-3 and the horizon
value that we calculated for the case in which Tutwilers capital structure was nonconstant
during the forecast period but stabilized with 50% debt in the post-horizon period. The
interest tax savings in the horizon year are calculated from Table 23A-3, while the other
tax savings are provided in the file Ch23 Tool Kit.xlsx. These values are summed on the
last row of Table 23A-4. The value of operations is their present value when discounted at
the unlevered cost of equity:

$5.2 $5.6 $8.4 $9.4 $195.2


Vop 5 1 1 1 1 5 $133.0
1.11793 1.117932 1.117933 1.117934 1.117935

TABLE
23A-4 Shortcut APV Calculation

2015 2016 2017 2018 2019


FCF $3.2 $3.2 $5.6 $6.4 $ 6.8
Horizon value 185.1
Interest tax saving 2.0 2.4 2.8 3.0 3.3
FCF, tax saving, and HV $5.2 $5.6 $8.4 $9.4 $195.2

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23A-10 Web Extension 23A The Adjusted Present Value (APV) Approach

This gives the value of the firms operations, without separating out the unlevered value and
the value of the tax shield. These calculations are simpler because a final interest expense
consistent with the long-term capital structure need not be calculated, nor must separate
unlevered values and tax shield values be calculated. This simplified calculation is also
called the compressed adjusted present value model.4

4See S. N. Kaplan and R. S. Rubak, The Valuation of Cash Flow Forecasts: An Empirical Analysis, Journal of Finance,

September 1995, pp. 10591093, for a discussion of the compressed adjusted present value model.

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