How can you use the adjusted present value approach to value a company undergoing major restructuring?

1 What is the APV approach?

The APV approach is a valuation method that calculates the value of a company as the sum of two components: the present value of the unlevered cash flows from its operations, and the present value of the financing side effects. The unlevered cash flows are the cash flows that the company would generate if it had no debt or interest payments. The financing side effects are the benefits or costs that arise from the company's financing decisions, such as tax shields, bankruptcy costs, or agency costs. The APV approach assumes that the financing side effects are independent of the company's operations and can be valued separately.

2 Why use the APV approach for restructuring?

The APV approach is useful for valuing a company undergoing major restructuring because it allows you to isolate the impact of the restructuring on the company's value. By comparing the APV before and after the restructuring, you can measure the value creation or destruction from the restructuring. For example, if a company acquires another company, you can use the APV approach to estimate the synergy value from the acquisition by subtracting the APV of the two standalone companies from the APV of the combined company. Similarly, if a company divests a division, you can use the APV approach to estimate the value loss or gain from the divestiture by subtracting the APV of the remaining company from the APV of the original company.

3 How to calculate the APV of a company?

To calculate the APV of a company, you need to estimate the following inputs: the unlevered cash flows from its operations, the cost of unlevered equity, and the present value of the financing side effects. The cost of unlevered equity is the required return on the company's equity if it had no debt. The present value of the financing side effects depends on the type and amount of debt that the company uses. The most common financing side effect is the tax shield, which is the reduction in taxes due to the deductibility of interest payments. Other financing side effects may include bankruptcy costs, agency costs, or subsidies. The formula for the APV of a company is:

APV = PV(unlevered cash flows) + PV(financing side effects)

4 How to estimate the unlevered cash flows?

The unlevered cash flows are the cash flows that the company would generate if it had no debt or interest payments. To estimate them, you can use one of the following methods: the free cash flow to the firm (FCFF) method, or the residual income (RI) method. The FCFF method calculates the unlevered cash flows as the cash flows available to all the investors (equity and debt holders) after deducting the operating expenses, taxes, and capital expenditures. The RI method calculates the unlevered cash flows as the excess of the operating income over the required return on the invested capital. Both methods should yield the same result, but the FCFF method is more widely used in practice.

5 How to estimate the cost of unlevered equity?

The cost of unlevered equity is the required return on the company's equity if it had no debt. To estimate it, you can use one of the following methods: the capital asset pricing model (CAPM), or the dividend discount model (DDM). The CAPM method calculates the cost of unlevered equity as the risk-free rate plus the product of the equity beta and the market risk premium. The equity beta is the measure of the systematic risk of the company's equity. The market risk premium is the difference between the expected return on the market portfolio and the risk-free rate. The DDM method calculates the cost of unlevered equity as the dividend yield plus the expected growth rate of dividends. Both methods should yield the same result, but the CAPM method is more widely used in practice.