Why is the compressed adjusted present value approach appropriate for situations with a changing capital structure?

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Why is the compressed adjusted present value approach appropriate for situations with a changing capital structure?

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Why is the compressed adjusted present value approach appropriate for situations with a changing capital structure?

Explanation & AnswerSolution by a verified expert

Explanation

The compressed 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.  By eliminating the impact of debt on the target company's shareholders, the acquiring company can easily capture the target company's risk to the equity investors.
 
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 compressed adjusted present value approach is based on 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 compressed adjusted present value method is suitable for variable capital structure.

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