Question

Explain why the APV model is suited for situations in which the capital structure is changing during the forecast period.

Answer 1

Adjusted present value is very similar to npv transactions, with minor variations.

The apv method does not use the weighted average cost of capital but rather uses the cost of equity as the discount factor.

The tax benefit of debt is included in the cash flow computations. This is effective in deals where the leveraging effect is of primary importance to the deal evaluation.

However for the added risk of additional debt burden, the value should be penalized for the added risk, and an adjusted apv value is obtained for evaluation.

With constant changes in capital structure estimated, this would be a better value, since

1. Cost of equity is higher than debt, hence that is blended into the enterprise value

2. APV Yields a more conservative estimate