Companies use different methods for valuing their businesses. APV (adjusted present value) is one of these methods. Two others are the weighted average cost of capital (WACC) and the capital cash flow (CCF). All three valuation methods value the entire company but have differences in the way taxes are shielded. These methods assume that the value of a company’s assets should equal the value of claims against those assets.
The APV business valuation method separates the value of operations of the capital structure into two parts: the value of the firm (not counting debt) and the benefits and costs of borrowing money. The equation used for this valuation method is: value of the firm=value of the un-leveraged firm + present value of interest tax shields – costs of financial distress. To calculate the value of the un-leveraged firm, the cash flows on return on assets is discounted. A tax shield represents the amount of income taxes a company pays, and the tax amounts vary by accounting methods. Companies using this method take the risk in overvaluing the company based on ignoring the real costs of financial distress. This method begins with the value of the firm with no debt and adjusts accordingly by adding the present value of the tax shield and finally adding the costs of financial distress, or the amount the effects of borrowing has on the company.
The weighted average cost of capital (WACC) is another valuation method used by many companies. This approach values the tax shield by adjusting the cost of capital. It begins with the amount of cash flow from operations (found on the cash flow statement) and discounts it to present value. The WACC method focuses on a company’s debt to value ratio (D/V). This method values the company by changes in this ratio. This ratio explains the company’s capital structure, which is how much of its capital is from debt and how much is from financing. A D/V ratio explains a lot about the company’s health. Companies with capital structures made up mostly from financing are typically more risky, and this decreases the value of the company. The equation used for this method is very complex and has many factors involved.
The CCF approach values the tax shield by incorporating it in the cash flow. The equation used for this approach is also very complex, containing many variables. This approach is calculated by starting with capital cash flows and discounting them. Those using this method believe that the tax shields are simple to calculate compared to the other methods. This method also bases its conclusion on the D/V ratio. All three methods typically calculate similar answers, but getting to the answers varies.