Title: The Adjusted Present Value Model
1The Adjusted Present Value Model
Where We Are Going
- We will examine how the APV model works,
including the Modigliani-Miller Propositions on
capital structure irrelevance, side effects of
leverage, and the pros and cons of the APV model
Chapter 11
2The Adjusted Present Value Model
- Highlights the effect of financial leverage on
the firm - Need to understand how leverage affects value
3The Adjusted Present Value Model
Financial Leverage
- The use of debt in a firm's capital structure
- APV model captures value created by leverage as a
separate item
4The Adjusted Present Value Model
Cash Flows and the Firm
COMQUITY
5Comparing the Free Cash Flow and Adjusted Present
Value Models
Given identical assumptions
- The free cash flow and APV models produce
identical results - See exhibit 11.3
- The only difference between the two valuation
models is the way they capture the value created
by leverage
6Comparing the Free Cash Flow and Adjusted Present
Value Models
Economic Balance Sheet
COMEQUITY
CORE
NONOP-DEBT-OCAP
Free Cash Flow Model
COMEQUITY
NONOP-DEBT-OCAP
PV(FCF_at_WACC)
Adjusted Present Value Model
COMEQUITY
NONOP-DEBT-OCAP
PV(FCF_at_Unlevered Cost of Equity) Value of
Leverage
7 The Modigliani-Miller Propositions and Value
- The additional value attributed to leverage under
the APV model is exactly equal to the increase in
value from using the WACC rather than the
unlevered cost of equity - The question is then, how do we calculate the
value of leverage? - Need to understand the MM proposal first
8The Modigliani-Miller Propositions and Value
The MM Propositions explain how the value of an
asset relates to how that asset is financed
is the value of equity if the firm is levered
is the value of the same firm's equity if it is
unlevered
9The Modigliani-Miller Propositions and Value
Continued
Original Formulation
- Leverage does not create value, if
- No taxes
- No costs to financial distress
- No operating effects of leverage
- Changing the form of capital cannot create or
destroy value - The amount, timing, and riskiness of the firms
aggregate cash flows available to all security
holders is constant
10Original Modigliani-Miller Capital Structure
Proposition
All Equity
50 Debt
Equity Value 1000.00 Cost of Equity 10
Equity Value 500.00 Cost of Equity 12
Debt Value 500.00 Cost of Debt 8
Original
No Taxes, etc.
11The Modigliani-Miller Propositions and Value
Continued
Original Formulation
- Identical assets (or bundles of assets) must sell
for the same price - X of debt plus X of equity in levered firm
provides identical cash flows to 100 of equity
in unlevered firm, so must sell for same price - A particular transaction does not create value
simply because it increases leverage. Instead,
leverage may cause side effects that create value
12Side Effects of Leverage
- Tax incentives
- Financial distress costs
- Operating effects
13The Modigliani-Miller Capital Structure
Proposition with Taxes
Shows that leverage does create value
- Capital structure may affect total tax payments
made by firm and all capital providers - If tax burden lowered, combined value to all
capital providers is raised - This lowers required rate of return to provide
capital suppliers with expected returns they
demand
14The Modigliani-Miller Capital StructurePropositio
n with Taxes Continued
Derived in Appendix 11.1
Marginal corporate tax rate
Marginal tax rate on personal interest
deductions
Marginal tax rate on personal income derived
from equity
15The Modigliani-Miller Capital StructurePropositio
n with Taxes Continued
- The benefits of debt in Exhibit 11.5
- Example below equation 11.3
- Firm value as a function of debt level in Exhibit
11.6 - Example of calculation of the value of leverage
in Exhibit 11.7
16Side Effects Financial Distress and Firm Value
Assuming financial distress is costly
- As the likelihood of financial distress increases
with higher leverage, the higher expected
financial distress costs offset the tax
advantages of leverage - That additional debt increases these expected
costs by more than the value of the additional
tax savings, additional leverage will actually
reduce firm value
17Side Effects Financial Distress and Firm Value
Continued
- See exhibit 11.8
- When using APV, we must also subtract this side
effect of leverage - However, it is very difficult to quantify these
costs and their effect on value - In practice, analysts often ignore financial
distress costs, which is usually not a big
problem for firms not highly levered - APV model without consideration of financial
distress costs overstates the value of equity
18How Leverage Affects Cost of Capital
The cost of capital adjusts for the tax benefits
of leverage without financial distress
0.110
0.105
0.100
0.095
Cost of Capital
0.090
Weighted-average cost of capital
0.085
0.080
Unlevered cost of capital
0
10
20
30
40
50
60
Debt as of Total Capital
19How Leverage Affects Cost of Capital
With financial distress
0.14
0.12
Cost of Capital
0.10
Weighted-average cost of capital without distress
0.08
Weighted-average cost of capital with financial
distress costs
0
10
20
30
40
50
60
Debt as of Total Capital
Unlevered cost of equity
20Pros and Cons of the Adjusted Present Value
Model
Pros
- Highlights the value created by leverage
- Similar to the free cash flow model
- Forecasting process is no more or less difficult
under one of these methods than the other - Because the two models discount the same cash
flow streams
21Pros and Cons of the Adjusted Present Value
Model Cont.
Cons
- When levered enough, financial costs are an
important consideration - Unlevered cost of equity will be misstated when
potential financial distress costs are high - Because the formula used to estimate the
unlevered cost of equity considers only the role
of taxes, not the role of the financial distress
costs
22Summary
We have learned
- The APV model focuses attention on the value
created by leverage - The free cash flow and APV models give identical
results
23Summary Continued
- The MM Propositions explain how the value of an
asset relates to how that asset is financed - Taxes generally provide incentive to lever, due
to structure of income tax rates - Financial distress costs and operating effects of
leverage also can affect value