APV and EVA Approach of Firm

Valuation
Module 8
 APV and EVA Approach of Firm Valuation
Advantages and Limitations of Cost of Capital Approach

Advantages:
• It incorporates the costs and benefits of borrowing.
• It is relatively simple.

Disadvantages:
• The free cash flows to equity are a much more intuitive measure of cash flows than cash
flows to the firm. When we estimate cash flows, we look at cash flows after debt
payments (free cash flow to equity) because we tend to consider interest payments and
the repayment of debt as cash outflows.

• Cost of capital approach, focus on pre-debt cash flows which sometimes blind us to real
problems with survival. For instance, assume that firm has free cash flows to the firm of
$100 million and because of large debt load its free cash flow to equity equal to -$50
million. Now the firm will have to raise $50 million in new funds to survive. Free cash
flows to equity alerts us with this problem while free cash flows to the firm are unlikely
to reflect this.
• The use of a debt ratio in the cost of capital to incorporate the effect of leverage requires
us to make implicit assumptions that might not be feasible or reasonable.
 APV and EVA Approach of Firm Valuation
Will Equity Value be the Same under Firm and Equity Valuation?

• The advantage of using the firm valuation approach is that cash flows relating to debt do
not have to be considered explicitly, since the FCFF is a pre-debt cash flow, whereas they
have to be taken into account in estimating FCFE.

• In cases where the leverage is expected to change significantly over time, this is a
significant saving, since estimating new debt issues and debt repayments when
leverages is changing can become increasingly messy the further into the future.

• In theory, the value for equity obtained from the firm valuation and equity valuation
approaches should be the same if you make consistent assumptions about financial
leverage.
 APV and EVA Approach of Firm Valuation
Will Equity Value be the Same under Firm and Equity Valuation?

Illustration 1:
Assume that the firm has 166.67 million in earnings before interest and taxes and a tax rate
of 40 percent. Assume that the firm has equity with a market value of 600 million, a cost of
equity of 13.87 percent, debt of 400 million and a pretax cost of debt of 7 percent. If the
firm has no reinvestment and no growth then estimate the value of firm using both FCFF
and FCFE approach.
Ans:
600 400
Cost of capital = (13.87%) (1000) + (7%)(1-0.4) (1000) = 10%

𝐸𝐵𝐼𝑇 (1−𝑡) 166.67 (1−0.4)

Value of the firm = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = = 1000 million
0.10

Value of equity = value of firm – value of debt = 1000 – 400 = 600

Now estimation of value of equity directly by estimating the net income:

Net income = (EBIT-Pretax cost of debt * Debt)(1-t)

(166.67 – 0.07 * 400)(1-0.4) = 83.202 million
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒 83.202
Value of equity = = = 600 million
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 0.1387
 APV and EVA Approach of Firm Valuation
Adjusted Present Value Approach (APV)

In the APV approach, we estimate the value of the firm in three steps.
• To estimate the value of the firm with no leverage
• To consider the present value of the interest tax savings generated by borrowing a given
amount of money.
• To evaluate the effect of borrowing the amount on the probability that the firm will go
bankrupt, and the expected cost of bankruptcy.

Value of unlevered firm: The first step in this approach is the estimation of the value of the
unlevered firm.
𝐹𝐶𝐹𝐹0 (1+𝑔)
Value of unlevered firm = 𝑝𝑢 −𝑔

Where, 𝐹𝐶𝐹𝐹0 is the current after-tax operating cash flow to the firm,
𝑝𝑢 is the unlevered cost of equity
g is the expected growth rate

The inputs needed for this valuation are the expected cash flows, growth rates and the
unlevered cost of equity. Unlevered cost of equity is estimated using unlevered beta.
 APV and EVA Approach of Firm Valuation
Adjusted Present Value Approach (APV)

Expected Tax Benefit from Borrowing: The second step in this approach is the calculation
of the expected tax benefit from a given level of debt.

(𝑇𝑎𝑥 𝑟𝑎𝑡𝑒)(𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡)(𝐷𝑒𝑏𝑡)

Value of tax benefits = = (Tax rate) (Debt) = 𝑡𝑐 D
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡

Estimating Expected Bankruptcy Costs and Net Effect: The third step is to evaluate the
effect of the given level of debt on the default risk of the firm and on expected bankruptcy
costs. If 𝜋𝑎 is the probability of default after the additional debt and BC is the present
value of the bankruptcy cost, the present value of expected bankruptcy cost can be
estimated,
PV of expected bankruptcy cost = (probability of bankruptcy)(PV of bankruptcy cast)
= 𝜋𝑎 BC
Probability of bankruptcy can be estimated indirectly by:
• One is to estimate a bond rating by using the empirical estimates of default probabilities
for each rating.
• The other is to use a statistical approach such as probit to estimate the probability of
default.
 APV and EVA Approach of Firm Valuation
Adjusted Present Value Approach (APV)

Bankruptcy Cost:
Research that has looked at the direct cost of bankruptcy concludes that costs are small,
relative to firm value (Warner, 1977). The indirect costs of bankruptcy can be substantial,
but costs vary widely across firms.

Shapiro and Titman (1984) speculate that the indirect costs could be as large as 25% to
30% of firm value but provide no direct evidence of the costs.

Altman (1984) estimates the cost to be 15% in a study of seven firms that went bankrupt
1980 – 1982.

J.N. Warner (1977), “Bankruptcy Costs: Some Evidence “ Journal of Finance. 32 : 337-347.

Shapiro, A. and Titman, S. (1984). “ The Effect of Capital Structure on a Firm’s Liquidation Decision”, Journal of
Financial economics. 13, 137-151.

Altman, E. (1984). “A further Empirical Examination of the Bankruptcy Cost Question,” Journal of Finance, 1067 -1089.
 APV and EVA Approach of Firm Valuation
Adjusted Present Value Approach (APV)

Illustration 2: (This exercise is based on the Illustration 1 of file name “Firm valuation
Model Module 8”)
1. The unlevered beta of Titan Cement is 0.8, while for the first five years, the risk-free
rate is 3.41% and a risk premium is 4.46%. Estimate the unlevered cost of equity.
2. Beyond year five, the unlevered beta is changed to 0.875 while its market risk premium
reduced to 4%. Estimate the cost of equity for stable period.
3. Estimate the Free cash flow to the firm and unlevered firm value based on below
information.
Year Current 1 2 3 4 5
EBIT (1-t) 172.76 182.25 192.26 202.82 213.96 225.72
Capex-Depreciation 49.20 40.54 42.77 45.11 47.59 50.21
Change in WC 51.80 11.47 12.11 12.77 13.47 14.21
4. Calculate the tax benefits from debt based on the Titan’s existing debt of 414 million
and a tax rate of 25.47%.
5. Based on the existing synthetic rating of AA, the probability of default at the existing
debt level is 0.28 percent. Estimate the expected bankruptcy cost if the cost of
bankruptcy is 30 percent of unlevered firm value.
 Cost of Capital Approach to Value the Firm

Intrinsic Valuation (Frees cash flow approach): Valuing Operating Assets

Illustration 2 (Cont..):Solution
(𝑁𝑒𝑡 𝐶𝑎𝑝𝑒𝑥+𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑊𝐶) (49+52)
2. Reinvestment rate = =231.8(1−.2547) = 58.5%
𝐸𝐵𝐼𝑇(1−𝑡)

3. Expected growth rate = Reinvestment rate * Return on capital

= .2854 * 19.25% = 5.49%

4. Unlevered cost of equity = 3.41% +0.80(4.46%)=6.98%

( Levered cost of equity: Cost of equity = Risk-free rate + Beta * risk premium
3.41% + 0.93 (4.46%) = 7.56%)

5. Unlevered stable period cost of equity = 3.41% +0.875(4%) = 6.91%

𝑔 3.41%
6. Reinvestment rate in stable growth = 𝑅𝑂𝐶 = 6.91% = 49.35%
 Cost of Capital Approach to Value the Firm

Intrinsic Valuation (Frees cash flow approach): Valuing Operating Assets

Illustration 2 (Cont..):Ans.

Year 1 2 3 4 5
EBIT 244.53 257.96 272.13 287.08 302.85
EBIT(1-t) 182.25 192.96 202.82 213.96 225.7
- Reinvestment 28.54 28.54 28.54 28.54 28.54
=FCFF 130.24 137.39 144.94 152.90 161.30
Cost of equity 6.98% 6.98% 6.98% 6.98% 6.98%
Cu. Cost of capital 1.0698 1.1445 1.2244 1.3098 1.4012
Present Value 121.74 120.05 118.38 116.73 115.12
Total 592.02

7. Cash flow one year after terminal year =

=EBIT (1-t) (1-reinvestment rate)
302.85(1+.0341)(1-.33)(1-.49.35)
= 106.28 million euros
106.28
terminal value (at end of year 5) = .0691 −.0341 = 3036.57 million euros
3036.57
Present value = (1+0.0698)5 = 2167.058
value of operating assets (2167.06+592.02) = 2759.078
 APV and EVA Approach of Firm Valuation
Adjusted Present Value Approach (APV)

Illustration 2: Solution
8. Expected tax benefits in perpetuity = Tax rate (Debt) = 0.2547*414 = 105.45 million

This captures the tax benefit on the dollar debt outstanding today and does not factor in
future debt issues (or increase in the debt ratio) and the tax benefits that will accrue from
that additional debt.

9. Expected bankruptcy cost = Probability of bankruptcy * cost of bankruptcy * (Unlevered

firm value +Tax benefits from debt)
0.0028 *0.30 *(2759 +105.45) = 2.41 million

Value of the operating assets = Unlevered firm value + PV of tax benefits – Expected
bankruptcy costs

=2759+105.45 -2.41 = 2862 million

In contrast, the value of operating assets is 2897.42 million with the cost of capital
approach. The difference between the two approaches can be attributed to the tax benefits
built into each one. The APV model considers the tax benefits only on existing debt,
whereas the cost of capital approach adds in the tax benefits from future debt issues.
 APV and EVA Approach of Firm Valuation
Cost of Capital versus APV Approach

• In an APV valuation, the value of a levered firm is obtained by adding the net effect of
debt to the unlevered firm value.

𝐹𝐶𝐹𝐹0 (1+𝑔)
Value of levered firm = 𝑡𝑐 D -𝜋𝑎 BC
𝑝𝑢 −𝑔

In the cost of capital approach, the effect of leverage show up in the cost of capital, with
the tax benefit incorporated in the after-tax cost of debt and the bankruptcy costs in both
the levered beta and the pretax cost of debt.

The value of the firm is different for both the approaches i.e. cost of capital and APV due to
the following reasons:

1. The models consider bankruptcy costs very differently, with the APV approach providing
more flexibility in allowing you to consider indirect bankruptcy costs. To the extent that
these costs do not show up or show up inadequately in the pretax cost of debt, the APV
approach will yield a more conservative estimate of value.
2. The second reason is that the APV approach considers the tax benefit from a dollar
debt value, usually based on existing debt. The cost of capital approach estimates
the tax benefit from a debt ratio that may require the firm to borrow increasing
amounts in the future.
 APV and EVA Approach of Firm Valuation

Excess Return Models ( Economic Value Added)

• Excess return models compute the value of a firm as a function of expected excess
returns – returns on equity (capital) that exceed the cost of equity (capital).

• Economic Value Added (EVA) is one of the variant of excess return models, a measure
popularized by Stern Stewart, a value consulting firm. EVA is a measure of the surplus
value created by an investment or a portfolio of investments.

Economic Value added = (Return on capital invested – cost of capital) * (capital invested)
= After-tax operating income – (Cost of capital) ( capital invested)

• We need three basic inputs to compute EVA:

- the return on capital (ROC) earned on investments
- the cost of capital for those investments
- the capital invested in them ( here it is best to estimate the capital invested from
the ground up, starting with the assets owned by the firm, estimating the value of these
assets and cumulating this market value.)
 APV and EVA Approach of Firm Valuation
Excess Return Models ( Economic Value Added and Net Present Value)

• The net present value of a project, which reflects the present value of expected cash
flows on a project, netted against any investment needs, is a measure of surplus value
created by the project.
• Thus, investing in projects with positive net present value will increase the value of the
firm, whereas investing in projects with negative net present value will reduce value.
• EVA is a simple extension of the net present value rule.
• NPV of the project is the present value of the EVA by that project over its life.

𝐸𝑉𝐴
NVP = σ𝑡=𝑛 𝑡
𝑡=1 (1+𝑘 )𝑡
𝑐
Where, 𝐸𝑉𝐴𝑡 is the economic value added by the project in year t and the project has a life
of n years.

• Value of the firm can be expressed in terms of value of assets in place + value of
expected future growth.
Firm value = Value of assets in place + Value of expected future growth
 APV and EVA Approach of Firm Valuation
Excess Return Models ( Economic Value Added and Net Present Value)

• Under discounted cash flow model, the values of both assets in place and expected
future growth can be expressed in terms of NPV created by each component.

Firm Value = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑𝐴𝑠𝑠𝑒𝑡 𝑖𝑛 𝑝𝑙𝑎𝑐𝑒 + 𝑁𝑃𝑉𝐴𝑠𝑠𝑒𝑡𝑠 𝑖𝑛 𝑝𝑙𝑎𝑐𝑒 + σ𝑡=∞

𝑡=1 𝑁𝑃𝑉𝐹𝑢𝑡𝑢𝑟𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡𝑠,𝑡

• Substituting the EVA version of NPV into this equation:

𝐸𝑉𝐴𝑡,𝑎𝑠𝑠𝑒𝑡𝑠 𝑖𝑛 𝑝𝑙𝑎𝑐𝑒
Firm Value = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑𝐴𝑠𝑠𝑒𝑡 𝑖𝑛 𝑝𝑙𝑎𝑐𝑒 +σ𝑡=∞
𝑡=1 (1+𝑘𝑐 )𝑡
𝐸𝑉𝐴𝑡,𝑓𝑢𝑡𝑢𝑟𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡𝑠
+σ𝑡=∞
𝑡=1 (1+𝑘𝑐 )𝑡

• Thus value of the firm under EVA approach can be written as the sum of
-the capital invested in assets in place
-the present value of the EVA by these assets
-the expected present value of the economic value that will be added by future
investments.
 APV and EVA Approach of Firm Valuation

Illustration 3: (Economic value added)

Consider a firm that has existing assets in which it has capital invested of $100 million.
Assume these four additional facts about the firm:
1. The after-tax operating income on assets in place is $15 million. This return on capital of
15% is expected to be sustained in perpetuity and the company has a cost of capital of
10%.
2. At the beginning of each of the next five years, the firm is expected to make investments
of $10 million each. These investments are also expected to earn 15 % as a return on
capital and the cost of capital is expected to remain 10%.
3. After year 5, the company will continue to make investments and earnings will grow 5% a
year, but the new investments will have a return on capital of only 10%, which is also the
cost of capital.
4. All assets and investments are expected to have infinite lives. Thus, the asset in place and
the investments made in the first five years will make 15% a year in perpetuity, with no
growth.

Estimate the value of firm using EVA approach.

 APV and EVA Approach of Firm Valuation

Illustration 3: (Economic value added)

Ans:

Capital Invested in Assets in place 100

(0.15−0.10)(100)
+ EVA from assets in place = 50
0.10
(0.15−0.10)(10)
+PV of EVA from new investments in year 1 = 5
0.10

(0.15−0.10)(10)
+PV of EVA from new investments in year 2 = 4.55
(0.10)(1.10)1

(0.15−0.10)(10)
+ PV of EVA from new investments in year 3 = 4.13
(0.10)(1.10)2

(0.15−0.10)(10)
+ PV of EVA from new investments in year 4 = 3.76
(0.10)(1.10)3

(0.15−0.10)(10)
PV of EVA from new investments in year 5= 3.42
(0.10)(1.10)4

Value of Firm 170.85

 APV and EVA Approach of Firm Valuation

Illustration 3: (Economic value added)

Ans:
𝐸𝑉𝐴𝑡,𝑎𝑠𝑠𝑒𝑡𝑠 𝑖𝑛 𝑝𝑙𝑎𝑐𝑒
Firm value = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑𝐴𝑠𝑠𝑒𝑡 𝑖𝑛 𝑝𝑙𝑎𝑐𝑒 + +σ𝑡=∞
𝑡=1 (1+𝑘𝑐 )𝑡

𝐸𝑉𝐴𝑡,𝑓𝑢𝑡𝑢𝑟𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡𝑠
+σ𝑡=∞
𝑡=1 (1+𝑘𝑐 )𝑡

170.85 = 100 + 50+ 20.85

The value of existing assets is therefore 150 million and the value of future growth opportunity is 20.85
million.
 APV and EVA Approach of Firm Valuation

Illustration 4: (Economic value added)

The equivalence of traditional DCF valuation and EVA valuation can be illustrated for Titan
Cement.

High growth phase Stable-Growth phase

Length Five years Forever after year5
Growth Inputs
Reinvestment rate 28.54% 51.93%
ROC 19.25% 6.57%
Expected growth rate 5.49% 3.41%
Cost of capital Inputs
Beta 0.93 1.00
Cost of debt 4.17% 3.91%
Debt ratio 17.60% 17.60%
Cost of capital 6.78% 6.57%
General Information
Tax rate 25.47% 33.00%

Estimate the EVA for Titan Cement each year for the next five years and the present value of
the EVA.
 APV and EVA Approach of Firm Valuation

Illustration 4: (Economic value added)

Ans:

Year 1 2 3 4 5 Terminal year

EBIT (1-t) 182.25 192.26 202.82 213.96 225.72 209.83
Cost of capital 6.78% 6.78% 6.78% 6.78% 6.78% 6.57%
Capital invested at beginning
Of year 946.90 998.92 1053.79 1111.67 1172.74 1237.16
Reinvestment during year 52.01 54.87 57.88 61.06 64.42
Cost of capital * capital
Invested 64.17 67.69 71.41 75.33 79.47
EVA 118.08 124.57 131.41 138.63 146.25
PV @ WACC 110.59 109.26 107.95 106.65 105.37
PV of EVA 539.81
Capital invested Today 946.90
PV of EVA in perpetuity on
Asset in place 1410.71
Value of operating assets 2897.42

PV of EVA in perpetuity on asset in place in year 5

𝐸𝐵𝐼𝑇6 1−𝑡 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑6 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙6 ) 209.83 −(1237.16)(0.0657)
= = = 1410.71 million euros
(𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙6 )(1+𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙)5 (0.065)(1.0678)5
 APV and EVA Approach of Firm Valuation

Illustration 5: Using the APV Approach to Calculate Optimal Debt Ratio for Titan Cement

Part 1: Estimate the value of the unlevered firm from the market value of the firm today
based on below information.
-Market value of the firm today = 2,355 million euros
-Existing debt level = 415 million
-Tax rate = 25.47%
-Probability of bankruptcy = 0.28%
-Bankruptcy cost = 30 % of firm value

Ans.
PV of tax savings from existing debt= 415 *0.2547 = 106 million

PV of expected bankruptcy cost = Probability of default * Bankruptcy cost

= 0.28% * (30% *2355) = 7 million

Unlevered Firm value = current market value – tax benefit + Expected Bankruptcy costs
2355 – 106 + 7 = 2256 million
 APV and EVA Approach of Firm Valuation
Illustration 5: Using the APV Approach to Calculate Optimal Debt Ratio for Titan Cement

Part 2: Estimate the optimum debt ratio to optimize the firm value using APV approach and
based on the below information.

Debt Ratio(%) Debt Tax rate Bond Rating Probability of Default

0 0 25.47 AAA 0.01
10 236 25.47 AAA 0.01
20 471 25.47 AA 0.28
30 707 25.47 A 0.53
40 942 25.47 A- 1.41
50 1178 25.47 B+ 19.28
60 1413 25.47 CC 65.00
70 1649 25.47 CC 65.00
80 1884 20.00 C 80.00
90 2120 17.78 C 80.00
 APV and EVA Approach of Firm Valuation
Illustration 5: Using the APV Approach to Calculate Optimal Debt Ratio for Titan Cement

Part 2: Ans

Debt Ratio Debt Unlevered Firm Tax Benefits Expected Value of

(%) Value Value Bankruptcy cost Levered Firm

0 0 2256 0 0 2256
10 236 2256 60 0 2316
20 471 2256 120 2 2374
30 707 2256 180 4 2432
40 942 2256 240 11 2485
50 1178 2256 300 148 2408
60 1413 2256 360 510 2106
70 1649 2256 420 522 2154
80 1884 2256 377 632 2001
90 2120 2256 377 632 2001

The firm value is optimized at about 40% debt.