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. Using the unlevered cost of equity helps in eliminating the effect of debt on the capital structure. By eliminating the impact of debt on the target company's shareholders, the acquiring company can easily capture the target company's risk.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 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 the sum of unlevered value of operations and tax shield. Therefore, the adjusted present value method is suitable for variable capital structure.