Adjusted present value

Adjusted present value
See also
Free cash flow yield Asset base Income from operations Asset equity ratio Project evaluation methods Net yield Du Pont formula Tax preference theory Private equity investments

Adjusted present value - the net present value of the investment project, calculated from the conditions of financing only from equity deposits and adjusted for the value of the present value of additional effects arising from the use of other forms of financing (Ootjers S. 2007, p. 9).

This method has been firstly suggested in 1974 by professor of MIT – Stewart Clay Mayers (Rappaport A. 1994, p. 190). The idea behind the adjusted present value method expresses the principle of "divide and conquer." This method does not cover all side effects in one calculation, but they can be aaded into one formula. First, the base cost of the project is calculated, i.e. the cost of the project is being calculated separately, as an institution, that provides funding only through the issuance of shares. Then, the present value of the costs or benefits that are incurred by the firm is calculated. Finally, all of the present values are added up and the total contribution of the project to the change in the value of the company is estimated.

APV method is a part of Discounted Cash Flow model (which represents a forecast of expected cash flows (and their growth rates), with an assessment of the risks of obtaining these flows both at the company (enterprise) level and at the level of an individual shareholder.) There are 3 methods of discounted cash flow assessment (Damodaran A. 2002, p. 12):

• Equity Valuation – this method allows us to estimate the equity of the company.
• Firm Valuation – this method helps to evaluate the company as one, which involves the need to take into evaluation other holders of claims in the company (like bondholders, preferred shares, etc.) in addition to equity.
• Adjusted present value – divides company into parts. The evaluation process starts from the basic operations and then the impact on the value of debts and other claims not related to stocks is added.

Although in all three methods the expected cash flows are discounted, corresponding amounts of cash flows and the discount rates used vary depending on the method chosen.

Calculation

The concept of Adjusted Present Value (APV) implies an adjustment of the current value of a project (or company) and the value of the additional financial investemnts related to project (or company) (Horne J., Wachowicz J. 2008, p.408): Failed to parse (unknown function "\space"): {\displaystyle APV=NPV+PV\space(side\space effects)} Where: NPV - current value of the investment project or company; PV (side effects) - current cost of side investments related to project (company).

Thus, the algorithm for calculating the APV involves (BPP Learning Media 2017, p. 89):

• evaluation of an investment project (or company) financed only by own funds;
• identification of side effects associated with the financing of the project (or company);
• calculation of the present value of the costs or benefits that will bring additional (side) effects;
• summation of the baseline NPV side effects.

So more officially calculation of Adjusted Present Value is (Horne J., Wachowicz J. 2008, p.408): $APV={\begin{bmatrix}\sum _{t=1}^{n}{\frac {CF_{t}}{(1+k_{e})^{t}}}-ICO\end{bmatrix}}+{\begin{bmatrix}\sum _{t=1}^{n}{\frac {(I_{t})(T_{c})}{(1+k_{d})^{t}}}-F\end{bmatrix}}$ Where: CF_t - is a business/project running cash flow, with already deducted tax in a certain time t; ICO - is the essential cash outplay of the project; k_e (or k_eu) - is the necessary rate of recovery in case of lack of financial advantage; I_t - is the share payment quota of debt, which should be arranged on time t; T_c - represents corporate tax quota; k_d - financing charges of debt financing, calculated before tax; F - back-up support cost, after tax calculations.

Examples of Adjusted present value

• Adjusted present value is commonly used to determine the value of a project or investment when there is a cost of capital associated with different forms of financing. For example, a company may be considering a project that requires $100,000 in capital. The company can either finance the project by issuing debt or issuing equity. The adjusted present value would be the present value of the cash flows generated by the project, adjusted for the cost of financing the project with either debt or equity.
• Another example of the use of adjusted present value is in mergers and acquisitions. In a merger or acquisition, the target company's assets, liabilities, and cash flows are combined with the purchasing company's. The adjusted present value of the target company is the present value of the cash flows generated by the merger or acquisition, adjusted for the cost of financing the transaction.

Advantages of Adjusted present value

Adjusted present value (APV) is a valuable tool to evaluate the economic feasibility of a project by taking into account the costs and benefits of different financing options. The following are some of the advantages of APV:

• It accounts for the cost of capital associated with any external financing and the potential tax benefits from debt financing.
• It is a more accurate measure of the long-term value of a project by taking into consideration the time value of money.
• It allows for a comparison of different financing options to determine which is most beneficial for a given project.
• It can be used to compare the value of a project before and after financing, allowing for a more accurate measure of the true value of the project.
• It takes into account the value of non-cash flows such as depreciation and amortization, which may not be included in NPV calculations.

Limitations of Adjusted present value

The Adjusted present value (APV) has several limitations that should be taken into consideration when using this approach for evaluation of potential investments. These limitations include:

• The APV model assumes that the cost of debt and equity is fixed, which may not be the case in reality. This means that the model does not take into account any potential changes in the cost of financing that may occur over time.
• The model also assumes that the tax rate will remain constant, which may not be the case in reality. This means that the model does not take into account any potential changes in the tax rate that may occur over time.
• The model also assumes that the cost of capital is the same for all sources of finance, which may not be the case in reality. This means that the model does not take into account any potential differences in the cost of capital between different sources of finance.
• The model also assumes that the cost of debt and equity are both equal, which may not be the case in reality. This means that the model does not take into account any potential differences in the cost of debt and equity that may exist.
• Lastly, the model does not account for the potential risk of default associated with the use of debt financing. This means that the model does not take into account any potential losses that may result from the default of any loans taken out to finance the investment project.

Other approaches related to Adjusted present value

The following are other approaches related to Adjusted present value:

• Real options approach - This approach incorporates the value of the potential for change that is inherent in the project, allowing the investor to take advantage of opportunities that may arise from the project in the future.
• Marginal cost of capital approach - This approach considers the cost of capital associated with the project, taking into account the risk and the cost of financing.
• Capital budgeting approach - This approach focuses on the project's cash flows and the return on investment, seeking to maximize the total return on the project.
• Risk-adjusted return on capital approach - This approach takes into account the risk associated with the project, seeking to maximize the return on capital after considering the potential for risk.
• Cost of capital approach - This approach looks at the cost of capital associated with the project, considering the cost of financing and the risk associated with the project.

In summary, Adjusted present value is a tool used to evaluate the net present value of an investment project, taking into account the cost of financing and the value of additional effects. Other approaches related to Adjusted present value include the real options approach, marginal cost of capital approach, capital budgeting approach, risk-adjusted return on capital approach and cost of capital approach.

References

• BPP Learning Media (2017). ACCA P4 Advanced Financial Management, BPP Learning Media, London, p. 89;
• BPP Learning Media (2016). CIMA P3 Risk Management, BPP Learning Media, London, pp. 323-324;
• Damodaran A. (2002). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset, John Wiley & Sons, New York, p. 12;
• Horne J., Wachowicz J. (2008). Fundamentals of Financial Management, Pearson Education, Harlow, p. 408;
• Ootjers S. (2007). Adjusted Present Value. A study on the properties, functioning and aplicability of the adjusted present value company valuation model, University of Twente, Enschede, p. 9;
• Rappaport A. (1994). Creating Shareholder Value: A Guide For Managers And Investors, Simon and Schuster, New York, p.190.

Author: Veronika Tomilova

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