Question

In the context of recent research on the Weighted Average Cost of Capital (WACC), the Adjusted Present Value (APV) and the Flow-to-Equity (FTE), which of these methods would you use for the following companies (explain your choice).

a) A firm with uncertain growth rates for the next 10 years.

b) A start-up firm with no debt.

c) A start-up firm with debt.

d) A financially distressed firm that has excess levels of debt but significant accumulated tax credits.

Answer 1

Adjusted Present Value is used for the valuation of the projects with debts. APV includes both Net present value and Debt cost. APV is always preferred to highly leveraged projects which uses the benefits of raising debts like interest tax shield.

On the other hand, Flow-to-equity approach is used for the valuation of the company to know how much cash is available to the shareholders. Cash available to shareholders are arrived after paying all the expenses and debt of the company. With the help of this approach we used to see whether dividends and repurchase of the stocks are made with free cash flow to equity or some other financing is used.

Now, we will see which method will be used in the the following companies:

1)A firm with uncertain growth in the next 10 years: For this company we will use Flow to equity approach as growth of the company is uncertain and we likely to determine how much cash is available to shareholder after paying off it's expenses and debts.

2)A startup firm with no debt: For this type of company we will use flow to equity as this firm raises no debt and we will see how much amount is available to shareholders to pay the dividend and to repurchase the stocks.

3)A startup firm with debt: For this type of company we will use Adjusted Present Value approach as this company uses debt as a source of finance. Here, we want to see to which extent the firm is a leveraged.

4)A financially distressed firm with excess level of debt but significant accumulated tax credit: This firm will also use the Adjusted Present Value approach as it uses the debt on excess level. Through this approach of valuation we would like to see that whether a company is leveraged with the tax shield benefits as it is using high level of debt and the high level of debt sometimes have a probabilty that company might result in bad debts.