What is APV?
How APV Works
A company may finance a project or investment using shareholders' equity alone (i.e., without leveraged, or borrowed, cash flows). Under these circumstances, the company repays associated debts using the unleveraged cash flow from shareholder's equity. As a result, the company is entitled to significant tax deductions on the interest component of these payments.
These tax deductions put the company at an advantage as far as the project's ultimate profitability, because they help to increase the project's bottom line. For this reason, a company can analyze such a project's profitability using the adjusted present value (APV). This measure reflects the project or investment's NPV adjusted for the tax benefits from interest obligations on outstanding debts associated with the project or investment.
To illustrate, suppose company XYZ invests $1,000 in a project, $800 of which is equity and $200 of which is debt. The annual cash flow year after a year is projected to be $146. The tax rate is 25%, and both the interest and cost of debt are each 7%, while the return on equity is 15%.
APV = NPV + PV of debt financing advantages
NPV = -$1000 init. invest. + ($146 ann. ret. / 0.15 ret. on eq.) = -$26.67
PV of debt fin. adv. = (0.25 tax rate ($200 debt * 0.07 debt int.)) / (1 – (1 / (1 + 0.07 debt cost)))
= $3.5 / 0.0655
APV = -$26.67 NPV + $53.44 PV of debt fin. adv.
APV = $26.77
In this instance, the tax advantages to company XYZ for financing with equity alone make the project profitable as reflected in the positive APV. Were it not for these advantages, the project would not have been accepted on the basis of its negative NPV.
Why APV Matters
The APV measures the profitability of a project or investment in which tax deductions apply on the basis of debt financing through an un-leveraged equity cash flow. For this reason, the APV can be a useful measure for investments and projects with high levels of debt that would be transferred to the acquiring company if accepted.
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