How does the Adjusted Present Value (APV) method of business valuation work?
At the to take over or to sell It is very important for a company to have the right valuation The Adjusted Present Value (APV) method is a commonly used technique for estimating a company's value, especially when a company has a variable debt-to-equity ratio. In this article, we explain what the APV method is, when it's applied, and the key aspects involved. We also provide a step-by-step explanation with an example to clarify how the APV method works.
What is the APV method?
1. Value distribution
The Adjusted Present Value method calculates the value of a company by dividing it into two parts:
All equity value: This is the value of the company if it were financed entirely with equity, with no debt.
Tax shield value debt: This is the tax benefit of deducting interest on debt. This tax benefit increases the company's total value.
2. All equity value
The “all equity value” is calculated by discounting the company's future free cash flows at the cost of equity (KEU), assuming the company has no debt. This process is similar to the Discounted Cash Flow (DCF) method.
3. Tax shield value debt
The tax benefit, or "tax shield," is calculated as the net present value of the expected tax savings from deducting interest on debt. This benefit is also discounted at the cost of equity (KEU).
Why use the APV method?
Using the Adjusted Present Value (APV) method offers specific advantages in determining a company's value, especially when the equity-to-debt ratio is not constant. This method is valuable because it provides a detailed picture of the company's true value by calculating both the value of operating activities and the tax benefit of debt separately.
More accurate valuation of dynamic structures
: The APV method is particularly useful for companies with a changing equity-to-debt ratio. This allows for a more accurate assessment of the impact of debt financing on the company's value.
Gaining insight into the value of tax benefits
: The method specifically considers the tax benefit a company receives from deducting interest on debt. This provides a more complete picture of the company's value, which is especially relevant for companies with substantial debt.
Flexibility for companies with a dynamic structure
: The APV method is ideal for small and medium-sized businesses, where the equity-to-debt ratio often fluctuates. This flexibility makes the method very suitable for companies with a changing financial structure.
Essential technology for companies with complex financial structures
: The APV method offers in-depth valuation by considering both the company's operating value and the impact of debt. It's an indispensable technique for companies with a variable equity-to-debt ratio, as it provides detailed insight into the company's true value.
Step-by-step plan for the Adjusted Present Value (APV) method
The APV calculation consists of the following steps:
Step 1: Expected cash flows
Start by estimating the future free cash flow the company will generate, typically over a five- to ten-year period. These cash flows include all income and expenses, such as operating income, expenses, and capital expenditures.
Step 2: Cost of Equity and Terminal Value
Calculate the cost of equity (KEU) and determine the company's terminal value (the residual value) after the projection period. This is often done by assuming the expected cash flows after the projection period with a constant growth rate.
Step 3: Calculating the net present value of cash flows
Discount the expected future cash flows to their present value using the cost of equity (KEU). This gives the net present value of the future cash flows.
Step 4: Calculation of the present value of the tax benefit
Calculate the tax benefit (tax shield) from the interest deductions on the debt. This benefit is also discounted to its present value, based on the cost of equity (KEU).
Step 5: Calculation of the residual value (terminal value)
Calculate the company's residual value at the end of the projection period, assuming a constant growth rate for future cash flows. Discount this value to the present.
Step 6: Total value of the company
The total value of the company is the sum of the net present value of the expected cash flows, the tax benefit, and the residual value of the company. These values are added together to calculate the total value of the company according to the APV method.
Example of the Adjusted Present Value method
Let's put the APV method into practice with a concrete example.
Step 1: Expected cash flows
Suppose a company expects to generate the following free cash flows (FCF) over the next three years:
- Year 1: €100,000
- Year 2: €120,000
- Year 3: €140,000
In addition, the company has a loan of €300,000, which is repaid annually in €50,000. The cash flow in the residual value is €142,800.
Step 2: Cost of Equity and Terminal Value
We use a required return on equity (the cost of equity) of 20% per year. At the end of year 3, we estimate the company's terminal value (the residual value), assuming a constant growth rate of 2% for future cash flows after year 3 (€142,800).
Step 3: Calculation of the net present value of the cash flows
The formula to calculate the present value (discounted value) of a future cash flow is:
Present value of the cash flow = FCFt / (1 + KEU)n, where:
- FCFt = free cash flow in the year in question
- KEU = return requirement on equity (20%)
- n = the year in which the cash flow takes place
The present (cash) values of the annual cash flows are:
- Year 1: €100,000 / (1+0.20) = €83,333
- Year 2: €120,000 / (1+0.20)² = €83,333
- Year 3: €140,000 / (1+0.20)³ = €81,019
Step 4: Calculation of the present value of the tax benefit
The tax benefit through interest deductions (tax shield) is calculated using the formula:
Present value of tax shield = Kd x Tc x Dt / (1 + KEU)n at t = 0, where:
- Tax shield = tax benefit on the interest payable
- Kd = cost of debt (interest rate on debt)
- Tc = company tax rate
- Dt = value of the debt at time t
- KEU = return requirement on equity (20%)
- n = the year in which the cash flow takes place
The current values of the annual tax shield are:
- Year 1: €3,750 / (1+0.20) = €3,125
- Year 2: €3,125 / (1+0.20)² = €2,170
- Year 3: €2,500 / (1+0.20)³ = €1,447
Step 5: Calculation of the residual value (terminal value)
The residual value of operating activities is calculated using the formula:
Residual value = FCFt+1 / KEU – g, where:
- FCFyear t+1 = the cash flow in the year after year 3 = € 142,800.
- g = constant growth rate after year 3 (2%)
- KEU = return requirement on equity (20%)
The net present value of the residual value of operating activities is €459,105. The residual value of the tax shield is calculated in the same way and is €6,028.
Step 6: Total value of the company
The total value of the firm is the sum of the present value of annual cash flows, the present value of the tax shield, and the residual value of operating activities and the tax shield:
- Present value of cash flows: € 247,685.00
- Current value of the tax shield: €6,742.00
- Residual value of operating activities: € 459,105.00
- Residual value of tax shield: €6,028.00
So the total current value of the company is approximately € 719.560,-.
Conclusion
The APV method offers a detailed and flexible approach to determining a company's value, especially if it has a variable equity-to-debt ratio. It is a powerful technique for calculating both the value of operating activities and the tax benefits of debt, thus providing a comprehensive
company appreciation.
Tips for Effectively Using the Adjusted Present Value Method
The Adjusted Present Value (APV) method is a valuable business valuation technique, but its application requires care and attention to detail. Here are some key tips:
Be careful with the assumptions
: The APV method relies heavily on assumptions about future cash flows and the cost of equity. Ensure these assumptions are realistic and well-substantiated. Unrealistic forecasts can significantly impact the final valuation.
Use reliable financial data
: Accurate valuation requires reliable and well-documented financial data. Companies with stable financial performance are better suited to the APV method, as fluctuating figures can complicate valuation.
Consider the impact of debt
: The APV method is particularly useful when a company has a changing equity-to-debt ratio. Ensure that the tax shield calculation is performed correctly, as this has a significant impact on the company's overall value.
Hire an experienced valuation specialist
: The APV method requires specialized knowledge, especially when determining the value of tax benefits and accurately discounting cash flows. Engaging an experienced Registered Valuator is crucial for obtaining an objective and reliable valuation.
Why choose Match Plan?
With over 30 years of experience in business valuations, our experts can help you conduct a thorough and accurate APV valuation. We offer support with:
- Choosing the right valuation method for your business.
- Collecting the necessary data and documents for a reliable valuation.
- Performing financial and strategic analyses.
- Drawing up a clear and detailed valuation report.
Contact us and discover how we can help you obtain an objective and accurate valuation of your company.
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