APV Approach to Equity Value
Info: Page JavaScript may take time to load
Now that we have a horizon value for Ideko that summarizes the value of the firm’s free cash flow beyond the forecast horizon, we can combine it with our forecast for free cash flow through 20Y0 to estimate Ideko’s value today.
Because the debt is paid on a fixed schedule during the forecast period, the APV method is the easiest valuation method to apply (if we chose the DCF WACC method, because the debt to equity ratio changes each year, we would have to re-compute the WACC each year too).
Unlevered Value
The steps to estimate Ideko’s value using the APV method are shown in the spreadsheet
- First, we compute Ideko’s unlevered value \(V^U\), which is the firm’s value if we were to operate the company without leverage during the forecast period and sell it for its horizon value at the end of the forecast horizon.
- Thus, the final value in 20Y0 would be the continuation value we estimated earlier.
- The value in earlier periods includes the free cash flows paid by the firm (Ideko - Forecast FCFs), discounted at the unlevered cost of capital \(r_U\) that we estimated here (Ideko - Unlevered Cost of Capital)
Note:
In 20Y0, we use the horizon value of $292 million as the final “unlevered” value, even though this value might include future tax shields. This approach is correct as we are using the APV calculation only to value the additional tax shields earned during the forecast horizon. Combining discounting methodologies as we have done here is very useful in situations like this one in which the firm is likely to be recapitalized at the exit horizon.
Tax Shield
Next, we incorporate Ideko’s interest tax shield during the forecast horizon. The interest tax shield equals the tax rate of 35% multiplied by Ideko’s scheduled interest payments (Ideko - Capital Structure).
Because the debt levels are predetermined, we compute the value \(T^s\) of the tax shield by discounting the tax savings at the debt interest rate, \(r_D = 6.80 \text{ %}\):
\[\begin{align*} T^s_{t-1} = {\text{Interest Tax Shield}_t + T^s_t \over {1 + r_D}} \end{align*}\]Note:
When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project’s cash flows, so they should be discounted at the project’s unlevered cost of capital, rather than debt cost of capital.
Equity Value Estimate
Combining the unlevered value and the tax shield value gives the APV, which is Ideko’s enterprise value given the planned leverage policy. By deducting debt, we obtain our estimate for the value of Ideko’s equity during the forecast period. The APV calculations are shown below:
Tip: Double click a cell to view its formula
Thus, our estimate for Ideko’s initial enterprise value is $213 million (see above), with an equity value of $113 million. As Kleiner Perkins’ initial cost to acquire Ideko’s equity is $53 milion (Ideko - Acquisition Financing), based on these estimates the deal looks attractive, with an NPV of $113 million - $53 million = $60 million.
Important:
Missing Assets and Liabilities
When computing the enterprise value of a firm from its free cash flows, remember that we are valuing only those assets and liabilities whose cash flow consequences are included in our projections. Any “missing” assets or liabilities must be added to the APV estimate to determine the value of equity.
In this case, we deduct the firm’s debt and add any excess cash or other marketable securities that have not been included (for Ideko, excess cash has already been paid out and will remain at zero, so no adjustment is needed).
We also adjust for any other assets or liabilities that have not been explicitly considered. For example, if a firm owns vacant land, or if it has patents or other rights whose potential cash flows were not included in the projections, the value of these assets must be accounted for separately.
The same is true for liabilities such as stock option grants, potential legal liabilities, leases (if the lease payments were not included in earnings), or underfunded pension liabilities.
Feedback
Submit and view feedback