On The Equivalence Between the APV and the

WACC Approach in a Growing Levered Firm

Francesco Roncaglio
Laura Zanetti

IAFC – Institute of Accounting and Finance

Bocconi University
Viale Filippetti n.9, Milano
Italy

Phone: +39 02 58.36.36.21

Fax: +39 02 58.36.36.98
E-mail: francesco.roncaglio@uni-bocconi.it
laura.zanetti@uni-bocconi.it

EFM code: 210

 ABSTRACT

One of the most discussed topics in the corporate valuation

theory is the choice between the wacc approach (Modigliani-
Miller [1963]) and the APV (Myers [1974]).
Although in a steady state framework the choice is irrelevant
since the two approaches provide the same result, in a growing
firm context the WACC equation seems to be inconsistent with
the APV result.
In this paper we propose a new scheme to evaluate the tax
savings in a growing firm. The main idea is first to split the tax
savings generated by the outstanding debt (at time zero) from
tax savings generated by the future debt issues (undertaken
according with the assumption of a constant debt to equity ratio).
Once we’ve separated the two different tax savings we discount
them using two different discount rates: the cost of debt (kd) for
the “outstanding” tax savings and the unlevered cost of equity
(ku) for the tax savings due to the future debt issues.
Finally we show that using our model the MM [1963] equation
works both in a growing firm (g > 0) and in a steady state firm
(g = 0).

2
1. INTRODUCTION

The impact of leverage on the value of a firm and its overall cost of capital (wacc) has
been extensively analysed in the finance literature, beginning with the seminal works of
Modigliani and Miller [1958] and [1963]. In the 1963 article MM analysed how
corporate income taxes (tc) interact with the firm’s financing choices, demonstrating
that the value of a levered firm (WL) is equivalent to the value of an otherwise identical
but unlevered firm (WU) plus the value of the debt-related tax savings (WTS).
Therefore:

WL = WU + WTS

Given the unleverd cost of capital (ku), they derived the relationship between leverage
(θ) and the overall cost of capital (wacc):

wacc = k u ⋅ (1 − t c ⋅ θ ) [1.1]

The above relationship is known as the conventional wacc equation. According with
this result the value of a levered firm can be calculated by discounting the operating or
unlevered cash flows to the firm as a whole (fcfo) at the firm weighted average cost of
capital (wacc). This technique is known as the wacc approach.

Stewart Myers [1974] subsequently introduced another approach to valuing a levered

firm: the Adjusted Present Value (APV). The APV approach calculates the value of the
debt-related tax savings separately from the unlevered firm value.
Despite many finance theorists and practitioners have been debating on which is the
best approach to valuing a levered corporation, it is useful to remark that the main
difference between the APV and the wacc approach is not related to their outcome.
The two approaches differ from one other in the technique employed to integrate the
unlevered firm value with the value of the tax savings, that is: lowering the discount rate
in the wacc approach, adding them separately in the APV approach.

In this paper we show (section 2) that, although in a steady state framework the
equivalence between the two approaches is straightforward, the APV and the wacc
approach seem to provide different results in a steady growth framework (“the
problem”).
This inconsistency is not trivial and it has given birth to many doubts concerning the
correctness of the conventional wacc approach for valuing a growing firm.

3
In particular some authors has argued that the wacc equation should be modified by the
growth factor (Copeland, 2000), others remove such inconsistency stating that the
appropriate discount rate for the tax savings is the unlevered cost of equity (ku) rather
than the cost of debt financing (kd) (Ruback, 2000). Moreover some other claim that
“the value of tax shields is NOT equal to the present value of tax shields” (Fernandez,
2002).

In section 3 we demonstrate that an APV approach consistent with the conventional

wacc approach exists. We illustrate how we obtain this result and the hypothesis
underling our model.

Finally (section 4) we show how our model provides results consistent with the
conventional wacc equation both in a steady state and in steady growth framework.

2. THE PROBLEM

We start with the steady state case in order to show the equivalence between the
conventional wacc [1.1] approach and the APV, as developed by Myers; in the next
section we will show how the same result can be obtained in a steady growth
framework.

A steady state firm is a firm which has steady cash flows (g = 0) and holds a constant
debt to assets ratio (D/(D+E) = θ). These two hypothesis, taken together, imply that, if
the present financial structure is the target one (θ), than the firm is not expected to
undertake new debt issue nor to reimburse part of the outstanding debt.

Using the APV approach the value of a steady state firm can be computed as follows:

fcfo D0 ⋅ k d ⋅ t c fcfo
WL = + = + D0 ⋅ t c [2.1]
ku kd ku

where:

WL : levered value of the firm

ku : unlevered cost of equity

4
kd : cost of debt
D0 : outstanding debt
fcfo : expected cash flow from operation
tc : corporate tax rate

Otherwise, using the the wacc approach, the firm value can be computed according with
the following formula:

fcfo
WL = [2.2]
wacc

The wacc equation, stating the equivalence between the two approaches, can be found
imposing the equivalence between the 2.2 and 2.1:

fcfo fcfo
= + D0 ⋅ tc [2.3]
wacc ku

Before solve this equation it is useful to note that the outstanding debt (D0), according
with the financial leverage constancy hypothesis, is equal to the firm value multiplied
by the target debt to assets ratio (θ):

fcfo
D0 = WL ⋅ θ = ⋅ θ [2.4]
wacc

Consequently, equation 2.3 can be written as follows:

fcfo fcfo fcfo

= + ⋅θ ⋅ tc
wacc ku wacc

Finally, solving the above equation in order to obtain the wacc equation, we find the
following result:

wacc = k u ⋅ (1 − θ ⋅ t c ) [2.5]

The above relation is the conventional wacc equation [1.1].

Despite the conventional wacc equation satisfies the equivalence between the APV and
the wacc approach in a steady state framework, it seems not to provide the same result if
applied to a steady growth firm.

5
A steady growth firm is a firm whose cash flows are expected to grow in perpetuity at a
steady annual growth rate (g), this implying that also the value of the firm’s assets value
is expected to grow at the same rate g. Furthermore the firm is supposed to keep the
debt to asset ratio (θ) constant.
In such a case, in spite of what we’ve seen in the steady state framework, the firm is
expected to issue year by year new debt and so, according with the asset’s growth,
maintain the same leverage ratio (θ). This implies that both assets and debt must grow in
perpetuity at the same annual rate g (see figure 1).

Figure 1 - Debt and assets time-path for a steady growth firm

worth

ASSETS

DEBT

1 2 3 4 5 6 7 8 9 10 years
11

Given these assumptions, the value of a steady growth firm can be computed via the
APV approach:

fcfo1 D0 ⋅ k d ⋅ t c
WL = + [2.6]
ku − g kd − g

or using the wacc approach:

fcfo1
WL = [2.7]
wacc − g

6
where:

g : expected annual growth rate

fcfo1 : expected cash flow from operation at time 1, fcfo1 = fcfo0 ⋅ (1 + g )

Now, stating the equivalence between the two approaches (as we’ve done in the steady
state case) we can obtain the waccg equation consistent with the APV approach in a
steady growth framework:

fcfo1 fcfo1 D0 ⋅ k d ⋅ t c fcfo1 fcfo1 k ⋅t

= + = + ⋅θ ⋅ d c
wacc − g k u − g kd − g k u − g wacc − g kd − g

solving1 the above equation we obtain the following equation:

k −g
wacc g = k u −  u  ⋅ k d ⋅ t c ⋅ θ [2.8]
 kd − g 

Comparing equations 2.8 with 2.5 it seems unquestionable that the two different
frameworks lead to different wacc equations. Equation 2.8 explains why some authors,
as we’ve mentioned in section 1, argue that in a steady state framework the
conventional wacc equation should be modified in order to incorporate the growth
factor.

3. THE MODEL

Before introducing the model we start with a simple example. The following example is
useful to clarify the hypothesis underlying the model.
Suppose a steady state firm with an expected perpetual cash flow from operation (fcfo)
of 100 $ and an outstanding debt, at time zero (D0), of 500 $. In addition suppose that
the unlevered cost of capital (ku), the cost of debt (kd), and the tax rate (tc) are

1
For a growing firm the 2.4 must be modified, this means :
fcfo1
D0 = W L ⋅ θ = ⋅θ
wacc − g

7
respectively: 10%, 5%, 50%. Finally we assume there are no leverage costs related to
the outstanding debt.
Given these assumptions, the value of the firm can be computed using the conventional
APV approach [Myers 1974] as follows:

WL = WU + WTS
fcfo 100
WU = = = 1000
ku 0.1
WTS = D0 ⋅ t c = 500 ⋅ 0.5 = 250

The value of the company is the sum of two quantities: the unlevered firm value (WU)
and the value of the tax savings (WTS) generated by the outstanding debt.

W L = 1000 + 250 = 1250

Now suppose at time 0 the firm claims that at time 10 it will issue an additional 50% (α)
of debt, that means an amount of new debt equal to 250 $ (∆D = D0 ⋅ α ).
According with this new assumption the current value of the company should
incorporate, in addition to the value of the future tax savings generated by the
outstanding debt, also the value of the future tax savings (WTS-exp) which the expected
new debt will start to generate at time 10. Consequently the value of the company is
now the sum of three quantities:

WL = WU + WTS + WTS −exp

It is useful to remark that the future debt issue will start to generate additional tax
savings after n-years (n = 10). Therefore the present value of the tax savings WTS-exp
should be computed as it follows:

D0 ⋅ α ⋅ t c
WTS −exp =
(1 + k ts )n
In our example,

500 ⋅ 0.5 ⋅ 0.5

WTS −exp =
(1 + kts )10

8
In order to find the value of WTS-exp we need to define another variable: the discount rate
kts.
In particular kts should be related with the likelihood concerning the company’s new
debt issue (∆D). In other words kts should incorporate the risk that the company fail, at
time 10, to issue the new debt.
Unfortunately, without any additional information, is not easy to measure the likelihood
that the firm, at time 10, will truly undertake the new debt issue.
Even if the likelihood about the firm’s plan to issue new debt can not be directly
observed, the future debt issued could be strongly affected by the occurrence of some
exogenous events (“the cause-events”). In this circumstance the risk associated with the
new debt issue is the same risk related to the cause-event.

In order to disclosure this last point we introduce a third hypothesis: assume that the
firm’s unlevered cash flows (fcfo) are expected to grow in perpetuity with a constant
annual rate of 5%. In addition, suppose that the firm’s plan to issue new debt at time 10
depends on the firms ability to meet its growth target (5%). This means that the future
debt issue is related with the asset’s firm growth, the cause-event.
For the above mentioned reasons the unlevered cost of capital (ku) is the appropriate
discount rate kts, therefore:

500 ⋅ 0.5 ⋅ 0.5

WTS −exp = ≅ 48.20
(1 + 0.1)10
Now we apply the same scheme to a steady growth firm.
As we’ve already seen in the previous section a steady growth firm has the following
main features:

• firm’s assets grow in perpetuity with a steady annual growth rate (g);
• firm’s financial structure doesn’t change.

First, the two conditions mentioned above set up that, in order to keep the financial
structure constant, also the debt must grow at the same asset growth rate g. In such a
case the outstanding debt, at time n, (Dn) is related to the outstanding debt at time n-1 as
follows:

Dn = Dn −1 ⋅ (1 + g )

9
In other words, the above relation implies that each year the firm will issue a new
amount of debt (ΔD) equal to the debt outstanding the year before multiplied by the
growth rate g (see figure 2).

∆D = Dn −1 ⋅ g

Figure 2 - the debt growth in the steady growth framework

D(n-1)*g
worth
future
debt
issues

…
…

D2*g
D1*g
D0*g

Outstanding
debt at time 0 D0

0 1 2 3 4 5 6 7 8 years
9 n

In addition, in a steady growth framework is logical assuming a strong connection

between the debt future issues and the asset growth (g): whenever the firm’s assets
shouldn’t grow the firm will not issue any additional debt (according with its financial
structure constraint).

Following this scheme, the debt’s growing process can be split in two parts: 1. the
outstanding debt at time 0 (D0) and 2. the future debt issues the firm will undertake year
by year.

i
Di = D0 + ∑ D0 ⋅ (1 + g ) ⋅ g
n −1
[3.1]
n =1
1 4442444 3
Future debt issues

10
Since in a steady growth framework the debt is assumed to grow year by year without
end, the present value of the debt-related tax savings at time 0 (WTS) can be now
computed supposing that each debt issue generates an incremental value equal to the
same amount of debt issued multiplied by the corporate tax rate tc (as we’ve stated in
the steady state framework).
Thus we get the following equation:

D0 ⋅ (1 + g ) ⋅ g ⋅ tc
∞ n −1
WTS = D0 ⋅ tc + ∑
n =1 (1 + ku )n
where:

D0 ⋅ t c is the present value of the tax savings generated by the

outstanding debt (WTS-0);
D0 ⋅ (1 + g )
n −1
∞
⋅ g ⋅ tc is the present value of the tax savings generated by the
∑
n =1 (1 + k u ) n
expected future debt issues2 (WTS-exp).

Bringing together the value of the tax savings and the unlevered assets value we obtain
the value of the steady growth firm:

fcfo0 ⋅ (1 + g ) D0 ⋅ (1 + g )
n n −1
∞
⋅ g ⋅ tc
∞
WL = ∑ + D0 ⋅ t c + ∑
n =1
1
(1 + k ) 3 WTS −0 1
424u 44
44
n 12 3 n =1 (1 + k ) 3
424u 444
444
n

WU WTS − exp

fcfo1 D ⋅ g ⋅ tc
WL = + D0 ⋅ t c + 0 [3.2]
ku − g ku − g

The interesting feature of the above formula is its consistency with the conventional
wacc equation [1.1]. In order to demonstrate this result, we proceed in the same way
we’ve already illustrated in the previous cases, that means imposing the equivalence
between the 3.2 and the 2.7:

2
The rational using the same discount rate we use to discount the “asset’s flows” (fcfo) should be clear:
whenever the firm’s assets shouldn’t grow the firm will not issue any additional debt.

11
 fcfo1 fcfo1 D ⋅ g ⋅ kd ⋅ tc
= + D0 ⋅ t c + 0
wacc − g k u − g ku − g

now substituting D0 (see footnote 1) we get:

fcfo1 fcfo1 fcfo1 fcfo1 g ⋅ tc

= + ⋅θ ⋅ tc + ⋅θ ⋅ [2.10]
wacc − g k u − g wacc − g wacc − g ku − g

Solving the above equation (for algebraic demonstration see the appendix) we obtain:

wacc g = k u ⋅ (1 − θ ⋅ t c )

This result is the same we’ve obtained for a steady state firm (see 2.5) and it
demonstrates, as we’ve previously claimed, that an APV approach consistent with the
conventional wacc equation exists even in a growing framework.

4.1 CONCLUSIONS

Despite the widespread use of the conventional wacc equation, there is a great
uncertainty about its use in a steady growth framework. This ambiguity is mainly due to
the fact that in a growing framework the APV approach and the traditional wacc
equation seem to lead to different results (section 2).
In this paper we’ve demonstrated (section 3) that an APV approach consistent with the
wacc approach exists not only in a steady state framework but also in the steady growth
context.
Our model differs from the traditional APV approach (2.6) essentially in the way of
discounting the tax savings. As illustrated in the paper (section 3) the rational dwells in
the relation of cause and effect between assets growth (the cause) and debt growth (the
effect).
In addition, our model can be seen as a generalization of the traditional APV approach.
In fact, if applied to a steady state firm (i.e. g = 0), it still provides a result consistent
with the wacc approach.

12
 APPENDIX

fcfo0 ⋅ (1 + g ) D0 ⋅ (1 + g )
n n −1
∞ ∞
⋅ g ⋅ tc fcfo1 D ⋅ g ⋅ tc
WL = ∑ + D0 ⋅ t c + ∑ = + D0 ⋅ t c + 0
n =1 (1 + k u ) n
n =1 (1 + k u ) n
ku − g ku − g
fcfo1
WL =
wacc − g
fcfo
D0 = W L ⋅ θ = ⋅θ
wacc − g

fcfo1 fcfo1 fcfo1 fcfo1 g ⋅ tc

= + ⋅θ ⋅ tc + ⋅θ ⋅ [3.2]
wacc − g k u − g wacc − g wacc − g ku − g

1 1 1 1 g ⋅ tc
= + ⋅θ ⋅ tc + ⋅θ ⋅
wacc − g k u − g wacc − g wacc − g ku − g

k u − g = wacc − g + (k u − g ) ⋅ θ ⋅ t c + θ ⋅ g ⋅ t c

wacc = k u − k u ⋅ θ ⋅ t c + θ ⋅ g ⋅ t c − θ ⋅ g ⋅ t c

wacc = k u − k u ⋅ θ ⋅ t c

wacc = k u ⋅ (1 − t c ⋅ θ )

13
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