Equity Valuation

Question 1

What is the “Adjusted Present Value” (APV) Method?

Answer 1

It is a financial modeling technique where you the value the asset as if it were all equity financed and then add in the tax shields from debt financing

The advantage this has over the WACC is that it can account for a changing capital structure and allows you to analyze key drivers of value. APV is more theoretically sound

It will lead to the same value as the WACC if capital structure is constant ( i.e. no change)

Question 2

What are some practical flaws with the APV method?

Answer 2

The first issue is that most practioners who use the APV method ignore expected bankruptcy costs adding the tax benefits to an unlevered firm value to get the levered firm value makes debt seem like an unmixed blessing

• In this case, firm value will be overstated, especially at very high debt ratios, where the cost of bankruptcy is clearly not zero and, in some instances, the cost of bankruptcy is higher than the tax benefit of debt

Question 3

How do you calculate the APV method?

Answer 3

1. Estimate the value of the firm with no leverage (discount the expected FCF to the firm at the unlevered cost of equity - including unlevered beta)
2. Calculate the present value of the interest tax savings generated by borrowing a given amount of money (marginal tax rate multiplied by the total debt)
3. Evaluate the effect of borrowing the amount on the probability that the firm will go bankrupt, and the expected cost of bankruptcy (probability of bankruptcy x cost of bankruptcy x unlevered firm value)

Question 4

Discuss the interest tax shield and taxes paid as it pertains to the APV Method

Answer 4

If the projected taxes to be paid exceed the interest tax shield generated in a given year, the entire ITS is consumed in that year and ITS carryforward is accumulated

If the company has more ITS in a given year than taxes paid, you can either

1. ) Carry the excess ITS back up to 3 years to offset taxable income in those years
2. ) If you cannot use it on past taxes, you must carry the ITS forward up to 15 years to offset future taxes, and can begin using the unused portion once you reach a year in which the all-equity tax bill exceeds the new ITS generated

Therefore, the actual ITS used in a given year equals the minimum of the calculated ITS and the projected taxes before the ITS is applied

Note: the discount rate to use is the CAPM rate, the same used to discount the FCF

Question 5

What is a tax loss carry-forward?

Answer 5

The tax loss carryforward is calculated as the tax rate x the net income loss in that respective year

Question 6

Discuss NOL’s and their application

Answer 6

NOLs can be carried back 2 years to recover past taxes paid, and forward 20 years to offset taxable income in future periods. NOLs are recorded on the balance sheet as a DTA

You always want to use the NOL as soon as possible in order to maximize the present value

For stock acquisition deals (Section 382), the target’s NOLs are under a strict tax code - NOL use is limited to the [purchase price of target’s stock x IRS long-term exempt rate]