3.Theinterestexpensesareequaltothepretaxcostofdebt
multipliedbythemarketvalueofdebt.Ifafirmhasolddebt
onitsbookswithinterestexpensesthataredifferentfromthis
value, the two approaches will diverge.
Ifthere isexpected growth,thepotential forinconsistency
multiplies.Wehavetoensurethatweborrowenoughmoney
to fund newinvestments to keepour debtratio ata level
consistentwithwhatweareassumingwhenwecomputethe
cost of capital.
ADJUSTED PRESENT VALUE APPROACH
Intheadjustedpresentvalue(APV)approach,webeginwith
thevalueofthefirmwithoutdebt.Asweadddebttothefirm,
weconsidertheneteffectonvaluebyconsideringboththe
benefitsandthecostsofborrowing.Todothis,weassume
thattheprimarybenefitofborrowingisataxbenefitandthat
themostsignificantcost ofborrowingis theaddedrisk of
bankruptcy.
Mechanics of APV Valuation
IntheAPVapproach,weestimatethevalueofthefirmin
threesteps.Webeginbyestimatingthevalueofthefirmwith
noleverage.Wethenconsiderthepresentvalueoftheinterest
tax savings generated by borrowing a given amount of
money. Finally, we evaluate the effect of borrowing the
amountontheprobabilitythatthefirmwillgobankrupt,and
the expected cost of bankruptcy.
Value of Unlevered Firm