The Adjusted Present Value Model

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The Adjusted Present Value Model

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... and Adjusted Present Value Models. Given identical ... Example of calculation of the value of leverage in Exhibit 11.7 ... Adjusted Present Value Model Con't. ... – PowerPoint PPT presentation

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Title: The Adjusted Present Value Model


1
The 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
2
The Adjusted Present Value Model
  • Highlights the effect of financial leverage on
    the firm
  • Need to understand how leverage affects value

3
The 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

4
The Adjusted Present Value Model
Cash Flows and the Firm
COMQUITY
5
Comparing 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

6
Comparing 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

8
The 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
9
The 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

10
Original 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.
11
The 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

12
Side Effects of Leverage
  • Tax incentives
  • Financial distress costs
  • Operating effects

13
The 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

14
The 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
15
The 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

16
Side 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

17
Side 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

18
How 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
19
How 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
20
Pros 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

21
Pros 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

22
Summary
We have learned
  • The APV model focuses attention on the value
    created by leverage
  • The free cash flow and APV models give identical
    results

23
Summary 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
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