The three components of the APV formula
APV = NPV of FCFs at Unlevered Cost of Equity + PV of Tax Shields − PV of Distress Costs
When APV beats WACC across leverage regimes
| When to Use | WACC | APV |
|---|---|---|
| Stable leverage | Preferred — simpler | Works but unnecessary |
| Changing leverage | Inaccurate — WACC changes each year | Preferred — handles changing debt explicitly |
| LBO/restructuring | Misleading | Essential — debt changes dramatically |
| Tax shields at risk | Assumes full utilization | Can model uncertain tax shields separately |
Why changing leverage breaks WACC
APV is intellectually cleaner than WACC because it doesn’t mix operating value with financing effects. When a company’s leverage is changing (LBOs, restructurings, high-growth companies), WACC gives wrong answers because it assumes constant capital structure.
Value an LBO target with APV versus WACC
Which method for a debt paydown
Tax shields minus the fragility they buy
Is WACC still valid post-LBO
Why the T x D tax-shield shortcut breaks
The familiar T x D shortcut for the value of tax shields is not a free-standing fact -- it silently presumes PERPETUAL, FIXED-dollar debt whose shields are discounted at the cost of debt (Kd). Each year the shield is T x Kd x D, a level perpetuity as safe as the interest payments generating it; discount that perpetuity at Kd and the Kd terms cancel, so the value telescopes to T x D. Change the debt policy and the shortcut breaks: if the company instead targets a leverage RATIO, debt tracks firm value, so future shields fluctuate with the business and inherit business risk -- they belong at the unlevered cost of capital (Ku), which is higher than Kd and therefore produces a SMALLER shield value. The Hamada unlever/relever formula with its (1 - T) factor (the WACC path's unlevering-and-relevering module) bakes in the same fixed-debt, Kd-flavored assumption. Practical rule: fixed amortizing debt on a contractual schedule (LBOs, project finance) justifies Kd-flavored shields; a ratio-targeting compounder that rebalances debt as it grows justifies Ku. Pick the discount rate that matches the debt policy, not the one that gives the bigger number.
Sit with the ideas.
A company generates $80M annual FCFF (perpetuity). Unlevered cost of equity is 12%. It has $500M of permanent debt at 6% interest. Tax rate is 25%. Using APV, what is the firm value?