The value of the firm at the end of the last year for which unique cash flows are projected is known as the terminal value. The terminal value is important because it can represent 50% or more of the total value of the firm.

Three Discounted Cash Flow Methods for Valuing Levered Assets

The APV approach first performs the valuation under an unlevered all-equity

assumption, then adjusts this value for the effect of the interest tax shield:

where VL = value if levered;

VU = value if financed 100% with equity;

PVITS = present value of interest tax shield.

The unlevered value is found by discounting the unlevered free cash flow at the required return on assets. The present value of the interest tax shield is found by discounting the interest tax shield savings at the required return on debt, rD.

The APV method is useful for valuing firms with a changing capital structure since the return on assets is independent of capital structure. For example, in a leveraged buyout, the debt to equity ratio gradually declines, so the required ROE and the WACC change as the lenders are repaid. However, when calculating the terminal value it may be appropriate to assume a stable capital structure, so in calculating the terminal value in a leveraged buyout situation the WACC method may be a better approach.

The flows to equity method sums the NPV of the cash flows to equity and debt.

Then,

The WACC method discounts the unlevered free cash flow at the weighted average cost of capital to arrive at the levered value of the firm.