Incorporating Competition into the APV Technique for Valuing Leveraged Transactions

According to a recent survey, the discounted cash flow approach is the valuation technique most widely used by companies evaluating acquisition targets. But because the DCF approach is inappropriate when the capital structure is changing during the forecast period, many analysts turn to the adjusted present value (APV) approach, which can easily accommodate a changing capital structure. Still, the finance literature has not shown how to incorporate assumptions about the effect of competition in the post‐forecast period into an APV analysis. This paper provides two new tools for calculating horizon values with changing leverage and competition. First, it provides a new model, based on more realistic assumptions, for valuing a growing annuity of free cash flows when ROIC is expected to decline due to competition. Second, it provides a model for valuing tax shields that correctly incorporates the impact of competition in the post‐forecast period. When used together with the APV approach, these two new tools allow an analyst to estimate the value of a company with a changing capital structure that faces competition in the post‐forecast period.