DuPont Corporation: Sale of Performance Coatings Harvard Case Solution & Analysis

What are some of the important features of APV, and why is it a useful approach for valuing an LBO?

Adjusted present value is basically an investment appraisal method, which also incorporate the concept of time value of value just like the basic discounted cash flow method. The difference with this method is that it is used to value a firm which is 100% financed by equity, therefore the valuation of the equity is performed separately as a base case.

Once the base case has been valued, then the valuation of the debt portion is performed which is normally significant in the case of an LBO transaction.

The financing benefits as a result of the tax savings are valued in this part. Some of the main features of APV are as follows:

  • The APV method is most probably used to value an LBO transaction and the reason for this is that the portion of debt in such a transaction is significant and therefore, its benefits are also significant which need to be valued separately.
  • The benefit associated with the excessive debt is the tax shield accruing to the company as a result of the interest paid on the outstanding balance of debt in each period.
  • The APV model is much similar to a discounted cash flow model, however, in the case of APV unlevered cash free cash flows are calculated, which exclude the impact of debt on those cash flows.
  • The unlevered cash flows are then discounted as the company’s cost of equity assuming the company is 100% equity financed.
  • The beta used in the CAPM formula for calculating the cost of equity is also not adjusted for the leverage.
  • The tax shield present value is calculated based upon the cost of debt of the company or the blended cost of debt if there are many types of debt taken by the company in a combination.
  • The total enterprise value in the case of APV is basically the sum of the present value of the tax shield, the present value of the unlevered free cash flows and the present value of the terminal value at the time of exit of the transaction.

Reasons for using APV Method for Valuation of LBO Model

As stated previously, an LBO transaction is based on a substantial amount of debt and the benefits of debt are substantial therefore, their value needs to be calculated separately which is the main reason for using an APV method for valuing an LBO transaction.

When the firm takes on significant levels of debt, its borrowing capacity is also increased significantly and as a result the benefits from tax savings on interest payments become significant.

Another reason for using the APV method in the LBO transaction that at time the amount of the debt borrowed by the company is significant but the cost of the debt is lower due to subsidized or a cheap loan taken by the company.

This low cost of debt has lower benefits therefore; the adjustments for the lost benefit and the present value for the tax relief are deducted from the present value of interest saved. It is not possible to use a DCF method in such a scenario.

The separation of the debt part and the equity part in the transaction gives a clear understanding of the complete transaction structure. The cost associated with the opportunities lost and the benefits of the transaction could be interpreted more easily.

These are the reasons for using APV as APV method could be easily used to evaluate all types of financing packages therefore, in the case of DuPont also, this method has been adopted by the private equity sponsors.........

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