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What is Adjusted Present Value approach?
Like Free Cash Flow (FCF) and Capital Cash Flow (CCF), Adjusted Present value (APV) is another way of evaluating an investment project. However, it is completely different from FCF and CCF approaches.
FCF and CCF are primarily related to interest tax shields and they do not consider the various financing effects that may affect the value of the investment project. In fact, most of the investment projects contain some form of financing effects and so Adjusted Present Value approach is a more utilized approach in practice.
It is known that FCF approach of evaluating a project is good when the debt-to-value ratio of the project is available. This means that when the debt-to-value ratio is obtained, one can easily evaluate the project in the FCF method. The FCF approach handles interest tax shield in the discount rate and hence, knowing the interest rate or calculating it is an integral part of the FCF approach.
On the other hand, the CCF approach is more convenient to use to evaluate a project's value when the debt of the project stays constant. The CCF approach handles interest shields in the cash flows. This means that in case of evaluation of a project that has fixed debt over the period of the project, it is more helpful to discount the interest tax shield in the cash flows of the project.
The Adjusted Present Value Approach
While evaluating a project, both the debt and debt-to-value ratio may change. In such circumstances, the FCF and CCF approaches fall short in calculating the value of the investment project. Moreover, when there are various financing effects that are applicable in a project, the net value of the project may change substantially. The APV approach considers these conditions while evaluating the value of a project.
The financing effects that may affect the value of an investment project may include subsidies, tax breaks, subsidized financing, and subsidies to projects in rural areas, etc. These effects may change the value of a project in a subtle manner and hence must be taken into consideration. That is where the APV approach comes in handy. The philosophy of the APV approach is based on the MM model of valuation of a levered firm.
$$\mathrm{Value\: of\: a\: Levered \:Firm \:= \:Value\: of\: Unlevered\: Firm \:+ \:Value \:of\: Interest\: Shields}$$
The value of a levered firm is an adjusted value that takes into consideration the various financing effects. It is equal to the value of all-equity levereed firm plus all the financing effects on the project.
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