What it means
The standard alternative is to discount cash flows at the weighted average cost of capital, which blends the cost of debt and equity into one rate. That works well when the mix of debt and equity stays roughly constant, but it breaks down when borrowing is heavy at the start and repaid rapidly, because a single blended rate cannot describe a changing capital structure.
Adjusted present value avoids the problem by valuing the business as though it had no debt at all, discounting its cash flows at the unlevered cost of equity, which is the return investors would demand for the business risk alone. Every financing effect is then valued separately and added on.
The largest of these is normally the interest tax shield, the tax saved because interest payments are deductible. Other financing effects can be included in the same way, both positive and negative.
Subsidised loans and government grants add value, while costs of issuing debt or equity and the expected costs of financial distress subtract from it. The method is standard in leveraged buyouts, where a company is bought largely with borrowed money that is then paid down over several years.
It is also used in project finance, where a specific asset carries its own debt on a defined repayment schedule and the mix of funding changes every year by design. The practical advantage is transparency, since the model shows exactly how much of the value comes from the operating business and how much from clever financing.
That distinction matters to a board deciding whether a deal is genuinely attractive or merely a well structured tax position. The main challenge is estimating the unlevered cost of equity, which is not directly observable and is usually derived from listed peers by removing the effect of their debt.
Get that rate wrong and the base case value is wrong, and no amount of precision in the tax shield calculation will rescue it.
In practice
Real-world examples.
Example
A private equity firm modelling a buyout funds 70% of the purchase price with debt that will be repaid over six years. It values the target unlevered and adds the year by year tax shield separately, because a single weighted average cost of capital would misstate the value as the debt falls away.
Example
A renewable energy developer builds a wind farm with a fifteen year amortising loan and a government backed interest subsidy. Adjusted present value lets the finance team show the board how much of the project return comes from operations and how much from the subsidised funding.
Example
A manufacturer weighing a $30,000,000 factory expansion presents both a base case value assuming equity funding and a separate $4,200,000 of financing benefit. The board approves the project on the strength of the base case, treating the financing benefit as a bonus rather than the reason to proceed.
Think of it
“APV values the business piece by piece-operations first, then adding the value of financing benefits.
Formula
Calculation
Adjusted present value = base case net present value assuming all-equity funding + present value of financing side effects
A packaging business is considering a new production line costing $4,500,000. It expects the line to generate unlevered free cash flow of $500,000 a year indefinitely, and the unlevered cost of equity for this type of asset is 10%.
The base case value is $500,000 / 0.10 = $5,000,000, so the base case net present value is $5,000,000 - $4,500,000 = $500,000.
The company plans to fund $2,000,000 of the cost with debt it intends to keep in place permanently, and its corporation tax rate is 25%. For permanent debt, the present value of the interest tax shield equals the tax rate multiplied by the debt, which is 0.25 x $2,000,000 = $500,000.
Adding the two parts gives an adjusted present value of $500,000 + $500,000 = $1,000,000. In other words, half the value of this investment comes from the asset itself and half from the tax treatment of the borrowing used to buy it, which is exactly the sort of split a board should see before approving it.Case study
Seen in the real world.
This is an illustrative and clearly fictional example. Talbot Rail Components, an invented supplier of railway parts, was the target of a buyout by a fictional investment firm that planned to fund $60,000,000 of the $90,000,000 price with debt repaid over five years. The initial model discounted everything at a weighted average cost of capital of 8.5% and produced an equity value the sellers rejected as too low.
The deal team rebuilt the analysis using adjusted present value. Discounting the operating cash flows at an unlevered cost of equity of 11% gave a business value of $84,000,000, and valuing the declining tax shield year by year added $9,500,000, for an adjusted present value of $93,500,000.
In this fictional account the split changed the negotiation as much as the total did. The buyer could see that roughly $9,500,000 of the value depended on maintaining the debt structure and the prevailing tax rules, so it capped its offer at $91,000,000 and set a covenant limiting early repayment of the debt that generated the shield.
Watch out
Common mistakes.
- Discounting the cash flows at the weighted average cost of capital and then also adding a tax shield, which counts the benefit of debt twice.
- Using the levered cost of equity for the base case, when the whole point is to value the business as if it carried no debt at all.
- Valuing the tax shield as though it lasts forever when the debt is scheduled to be repaid within a few years.
Questions
People also ask.
When should I use adjusted present value instead of the usual method?
Whenever the debt level changes materially over time, such as in a buyout, a project financing or a turnaround funded by temporary borrowing.
What discount rate applies to the tax shield?
Practice varies, with the cost of debt used when the shield is as certain as the interest payments themselves, and the unlevered cost of equity used when the company's ability to use the deduction is uncertain.
Does adjusted present value give a different answer from the weighted average cost of capital approach?
Applied consistently to a stable capital structure the two should agree closely, and a large gap usually points to inconsistent assumptions rather than to a real difference in value.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%