Damodaran on Valuation

6.2. ADJUSTED PRESENT VALUE APPROACH

In the adjusted present value (APV) approach, we begin with the value of the firm without debt. As we add debt to the firm, we consider the net effect on value by considering both the benefits and the costs of borrowing. To do this, we assume that the primary benefit of borrowing is a tax benefit and that the most significant cost of borrowing is the added risk of bankruptcy.

6.2.1. Mechanics of APV Valuation

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

6.2.1.1. Value of Unlevered Firm

The first step in this approach is the estimation of the value of the unlevered firm. This can be accomplished by valuing the firm as if it had no debt, by discounting the expected free cash flow to the firm at the unlevered cost of equity. In the special case where cash flows grow at a constant rate in perpetuity, the value of the firm is easily computed.

where FCFF₀ is the current after-tax operating cash flow to the firm, ρ_u is the unlev-ered cost of equity, and g is the expected growth rate. In the more general case, ...