DCF Valuation Methods: APV and WACC

In business valuation using the Discounted Cash Flow (DCF) method, there are two primary approaches: the Adjusted Present Value (APV) method and the Weighted Average Cost of Capital (WACC) method. These methods are not interchangeable.

Choice of Method

The choice between APV and WACC depends on the availability of information and the organization’s policy regarding financial leverage.

WACC Method

The WACC method involves discounting financial cash flows using the weighted average cost of debt and equity. This method assumes that the financial leverage, i.e., the ratio of debt to equity (based on market values, not book values), will remain stable in the future. This assumption is fairly realistic because:

  1. Theoretical Optimal Financial Leverage: There is an optimal level of financial leverage that provides tax benefits, as interest on debt is tax-deductible. However, too much debt increases bankruptcy risk and associated costs.
  2. Industry Leverage Stability: There is observed stability in average industry leverage levels, despite differences across industries. These differences indicate the real possibility of equilibrium.

APV Method

The APV method is used when management does not plan to increase debt as the market value of equity grows, aims to pay off debt entirely, or has a specific plan until the horizon and then assumes increasing debt based on other principles (e.g., in line with profit growth).

In this method, the tax shield and operational profitability are separated. The tax shield is separated from cash flows and each is discounted separately at the unlevered rate (or sometimes at the cost of debt).

Practical Recommendation

It is advisable to model using one method and verify with the other. This is feasible because the unlevered discount rate and WACC differ only in the tax shield component. As known from MM theory, leverage does not impact operational risks or operational profitability.

WACC involves discounting future cash flows with the weighted average cost of debt and equity.

APV involves discounting future cash flows with the unlevered rate and then adding the discounted tax shield created by debt.

Note: Both methods should be used carefully and cross-verified to ensure accurate valuation.

Source:

Corporate Valuation Theory, Evidence and Practice – by M. E. Zmijewski; R. W. Holthausen