Question

An alternate approach to discounted cashflow valuation is the adjusted present value approach, where you value the firm with no debt (unlevered firm) first and then consider the value effects of debt. What is the fundamental difference between the cost of capital approach and the APV approach and why might they generate different answers?

Answer 1

The first reason for difference is that models consider bankruptcy costs very differently, with the adjusted present value providing more flexibility in considering indirect bankruptcy costs whether or not it shows up in the pre tax cost of debt. So ApV will yield a more conservative estimate of value. The second reason is that APV approach considers the tax benefit from a dollar debt value, usually based upon exisiting debt. The cost of capital approach estimates the tax benefit from a debt ratio that may require the firm to borrow increasing amounts in the future.