This question is related to Chapter 18 of Berk & Demarzo "Capital Budgeting and Valuation with Leverage".How do the calculations of the firm value using the APV method differ between the following assumptions?The growth rate of the EBIT and the debt-equity ratio will be constant The growth rate of the EBIT and the interest coverage ratio will be constant.The firm selects the optimal interest coverage ratio and maintains this ratio constant forever (corporate taxes are the only imperfection)Are the values that result different or equal?

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Asked Oct 30, 2019
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This question is related to Chapter 18 of Berk & Demarzo "Capital Budgeting and Valuation with Leverage".

How do the calculations of the firm value using the APV method differ between the following assumptions?

  1. The growth rate of the EBIT and the debt-equity ratio will be constant 
  2. The growth rate of the EBIT and the interest coverage ratio will be constant.
  3. The firm selects the optimal interest coverage ratio and maintains this ratio constant forever (corporate taxes are the only imperfection)

Are the values that result different or equal?

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Expert Answer

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Step 1

With constant debt-equity ratio

Adjusted Present Value is used to value a firm’s total investment by first calculating the unlevered value of the firm and then adding it to the interest tax shield to find the value of the firm with leverage.

It is calculated using the below formula:

v
PV (interest tax-shield)
where
vValue of Levered fim
V=Value of unl evered firm
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v PV (interest tax-shield) where vValue of Levered fim V=Value of unl evered firm

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Step 2

First step:

Calculate the present value of the free cash flow using an unlevered cost of capital

D
+
E+D
rn = Pretax WACC
E+D
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D + E+D rn = Pretax WACC E+D

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Step 3

Calculate the present value of interest tax shield as PV (interest tax shield)

Subtract present value of any cost assoc...

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