Steps involved in using the Adjusted Present Value (APV) approach

The Adjusted Present Value (APV) approach can handle both perpetual and uneven cash flows. It can be used in calculating the adjusted present value of a levered firm that has many financing effects. The APV approach divides the NPV into two basic parts −

  • The first part includes the all-equity NPV, assuming that the project is entirely financed by equity.

  • The second part consists of the interest tax shields and all types of financing effects.

We can write,

$$\mathrm{APV = All\:Equity\:NPV\:+\:Value\:of\:Financing\:Effects}$$

Steps in Adjusted Present Value Approach

The use of APV consists of three steps −

  • The first state of application of APV includes determination of "all equity" or base case NPV. The base case assumes that there is only equity that is used in the financing of the project. Therefore, the project does not have any other effect than equity financing. In such a project, the risks are limited only to operating risks and there is no need to calculate any other risk for this purpose. The after-tax cash flows or the Free Cash Flows are discounted by the opportunity cost of capital. The opportunity cost of capital in an "all equity" financing is what shareholder will ask for considering that the entire amount financed by equity.

  • Secondly, the present value of cash flows resulting from the "allequity" financing of the project should be calculated. The streams ofcash flows are discounted by the appropriate discount rateaccording to the risks. For example, the MM tax-included modelcontains a fixed debt, and the interest tax shields are considered as risky as debt. Therefore, the interest tax shields must be discounted by the market cost of debt in this scenario. However, in some cases, the interest tax shields may be as risky as the operating cash flows. In such cases, a higher discount rate is applied to the measure the value of interest tax shields. All other financingeffects of the project are then discounted at their risk-adjusted rates.

  • The third step involves adding the "all-equity NPV" and present value of the financing effects to get the project's NPV. The result is an important indicator of the health of the investment project as only the projects that have a positive result should be opted and the one resulting in a negative outcome should be rejected. In fact, negative NPV indicates destruction of shareholder’s value of the project. So, only the projects that have a positive APV should be considered for investment.

Note − It is notable that the evaluation of a project by the APV method considers the MM model that is corrected for tax applications.