How does the APV method separate the unlevered firm value from financing side effects?

The Adjusted Present Value (APV) method decomposes firm value into two distinct components: the value of the unlevered firm (as if 100% equity-financed) plus the present value of financing side effects (primarily the interest tax shield). This separation makes APV particularly useful when the capital structure changes over time.\n\nAPV Formula:\n\nV_levered = V_unlevered + PV(tax shields) - PV(financial distress costs)\n\nMore precisely:\nV_unlevered = sum of FCF_t / (1 + r_u)^t\nPV(tax shields) = sum of (r_d x D_t x t) / (1 + r_d)^t\n\nwhere r_u is the unlevered cost of equity and D_t is the debt level at time t.\n\nWorked Example:\n\nBarrington Logistics plans a leveraged expansion. It will borrow $15M initially, repaying $3M per year for 5 years. Unlevered cost of equity: 14%. Cost of debt: 7%. Tax rate: 30%.\n\nFree cash flows (unlevered basis):\n\n| Year | FCF | PV Factor (14%) | PV of FCF |\n|---|---|---|---|\n| 1 | $4.2M | 0.8772 | $3.684M |\n| 2 | $5.1M | 0.7695 | $3.924M |\n| 3 | $5.8M | 0.6750 | $3.915M |\n| 4 | $6.3M | 0.5921 | $3.730M |\n| 5 | $6.9M | 0.5194 | $3.584M |\n| Total | | | $18.837M |\n\nTax shields (debt reduces each year):\n\n| Year | Debt Outstanding | Interest (7%) | Tax Shield (30%) | PV at 7% |\n|---|---|---|---|---|\n| 1 | $15.0M | $1.050M | $0.315M | $0.294M |\n| 2 | $12.0M | $0.840M | $0.252M | $0.220M |\n| 3 | $9.0M | $0.630M | $0.189M | $0.154M |\n| 4 | $6.0M | $0.420M | $0.126M | $0.096M |\n| 5 | $3.0M | $0.210M | $0.063M | $0.045M |\n| Total | | | | $0.809M |\n\nAPV = $18.837M + $0.809M = $19.646M\n\nSubtracting the initial investment of $15M: NPV = $4.646M\n\nAPV vs. WACC:\n\n| Feature | APV | WACC |\n|---|---|---|\n| Changing debt levels | Handles naturally | Requires constant D/E assumption |\n| LBO/project finance | Ideal | Awkward |\n| Conceptual clarity | High (separates operating and financing) | Moderate (blends into one rate) |\n| Constant leverage | Works but unnecessary complexity | Simpler and preferred |\n\nUse APV when:\n- Debt is repaid on a fixed schedule (not maintaining constant leverage)\n- LBOs, project finance, or restructurings with known debt trajectories\n- You need to separately value financing effects for negotiation\n\nUse WACC when:\n- Target capital structure is constant\n- Firm rebalances leverage each period\n- Simpler communication is preferred\n\nCompare valuation methods in our CFA Corporate Issuers course.