What Is Adjusted Present Value?

The adjusted present value method (APV method) was first proposed by Myers. Under the adjusted present value method, each cash flow of the project is divided into two parts: one is the operating cash flow without leverage (all equity capital); the other is the cash flow linked to the project financing. Valuation of these two parts results in APV = value of the non-leveraged project + project financing value. The classification of cash flows is to adopt different discount rates. The APV method first assumes full equity financing of the project, calculates a basic present value, and adjusts according to the value increase or decrease caused by the planned financial strategy to obtain the final APV. The APV method avoids the large errors that may be caused by the weighted average of the cost of capital of different natures, and the value creation of various values is clear.

Adjusted present value method

The steps to adjust the present value method (APV) are:

(1) Performance

(1) Different discount rates are used to discount different types of cash flows, instead of discounting all cash flows at a uniform discount rate;

(2) The economic benefits of investment projects can be measured in sections. If the previous paragraphs have shown that they are economically feasible, then the additional advantageous parts in the latter stages may not be calculated.

(3) Generally has greater tolerance and plasticity, and can better adapt to international investment projects

Adjusted present value method is versatile and reliable, it will replace weighted average cost of capital as a discounted cash flow method for non-professionals to choose.

For managers operating a business, the question of choosing a valuation method is always a comparison of practical choices among various choices. What is the weighted average cost of capital? Like the weighted average cost of capital method, the adjusted present value method is also used to value operating or existing assets, that is, any existing asset that will generate future cash flows. This is the most basic and common valuation problem facing managers. So why choose the adjusted present value method instead of the weighted average cost of capital method? First, when the latter applies, the former is always applicable, and because the former requires fewer restrictive assumptions, sometimes the former is still applicable when the latter is not applicable; second, the latter is more likely to make serious mistakes than the former. But most importantly, the average manager will find that the ability to adjust the present value method comes from its ability to provide more management-related information. Adjusting the present value method can not only help managers analyze the value of assets, but also the source of value.

The discounted cash flow method all needs to predict the future cash flow, and then discount it at a discount rate that reflects its degree of risk to obtain the present value of the future cash flow. But the various methods differ in their implementation details, especially the treatment of the value created or destroyed by financial strategies. The adjusted present value method analyzes the financial strategy separately, then adds its value to the operating value, and applies the adjusted discount rate directly to the cash flow of the business (see the figure "Basic Ideas of Adjusted Present Value Method"). The weighted average cost of capital method reflects financial effects by adjusting the discount rate (cost of capital), and is considered to be able to handle financial effects automatically without any further adjustment.

In fact, the effect of weighted average cost of capital on financial effects has never been so good. Aside from the simple capital structure, the most common form of weighted average cost of capital only considers the role of taxes and is not very convincing. However, its attractive advantage is that it only needs to discount the budget once, which is a boon for users of calculators and scale slides in the past. This advantage is irrelevant today. High-speed spreadsheets make it easy to adjust the large number of discount operations required by the present value method. Twenty years after the adjusted present value method was first proposed, the decomposition of the value component not only provided rich information, but its cost became very low.

The adjusted present value method is very flexible. A skilled analyst can value in a way that is best understood by those who manage different parts of value. The basic framework can be highly refined or customized based on hobbies and circumstances, but a simple example will illustrate its essence.