Explain why the APV model is suited for situations in which the capital structure is changing during the forecast period.
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Explain why the APV model is suited for situations in which the capital structure is changing during the forecast period. |
Explanation
The adjusted present value approach in valuation is appropriate in situations where the capital structure is not constant. In this method, the value of operations is calculated using the unlevered cost of equity, which eliminates the effect of debt in the capital structure. The total amount of the tax shield is calculated separately. The total value of operations is thus the sum of unlevered value of operations and tax shield. Since the effect of both equity and debt on the valuation is calculated separately, this method is appropriate for varied capital structure. First, the value of operations is calculated assuming that it is an all-equity firm. The effect of financial risk(tax shield) is then added to calculate the final value of operations.
Verified Answer
The adjusted present value approach in valuation is appropriate in situations where the capital structure is not constant. This is because, in this method, the value of operations is calculated using the unlevered cost of equity, which eliminates the effect of debt in the capital structure. The total value of the tax shield is calculated separately. The total value of operations is thus the sum of unlevered value of operations and tax shield.