Financial Leverage and APV Model Quiz

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Questions and Answers

Financial leverage refers to

The firm’s ability to secure competitive prices for raw materials to use in manufacturing products
The excess cash flow available to a firm for future expansion activities
The use of debt in a firm’s capital structure (correct)
The raw value of firm’s core operations that can be used for future capital investment

Which statement is not correct about the Adjusted Present Value (APV) model?

To understand the relationship between value and leverage is necessary
Estimates the value of a firm’s core operations in two parts, with and without leverage
Discounts the free cash flow stream at the weighted-average cost of capital
Captures the value created by leverage better than the discounted free cash flow model (correct)

Assume that an all-equity financed company with cost of equity of 10% generates unlevered FCFs of 13 million in perpetuity. It plans to take on perpetual debt of $100m with interest rate of 5%. Tax rate is 20%. What is the value of this company after the change in capital structure?

$130m
$150m (correct)
$13m
$135m

Why is it not recommended to always use Discounted Cash Flow (DCF) over Adjusted Present Value (APV)?

DCF uses a single discount rate, unlike APV (C)

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Which factor is crucial for an analyst to understand in relation to the Adjusted Present Value model (APV)?

The relationship between value and leverage (D)

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In a scenario where a company has a high cost of equity and low debt capacity, which valuation model would be more suitable to use?

Adjusted Present Value (APV) (B)

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Flashcards

Financial Leverage

The use of debt in a company's capital structure to finance investments and potentially increase returns.

APV Model Effectiveness

The Adjusted Present Value (APV) model explicitly calculates the value added by leverage, providing a clearer view of its impact, unlike the discounted free cash flow model.

Company Value After Recapitalization

The value of the company after the change in capital structure is $150 million. This is calculated by adding the value of the unlevered firm ($130m) to the tax shield from debt ($20m).

Limitation of DCF Over APV

DCF uses a single discount rate, which may not accurately reflect the changing risk profile associated with different levels of leverage. APV is more flexible.

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APV Modeling

Understanding the relationship between value and leverage is crucial for accurately assessing how changes in a company's capital structure affect its overall value.

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Model Choice: High Equity Cost, Low Debt

Adjusted Present Value (APV) is more suitable because it allows for the explicit valuation of the tax shields generated by debt, even when debt capacity is limited and cost of equity is high.

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