APV = Unlevered NPV of Free Cash Flows and assumed Terminal Value + NPV of Interest Tax Shield and assumed Terminal Value: The discount rate used in the first part is the return on assets or return on equity if unlevered; The discount rate used in the second part is the cost of debt financing by period.
In detail: EBIT – Taxes on EBIT = Net Operating Profit After Tax (NOPAT) + Noncash items in EBIT – Working Capital changes – Capital Expenditures and Other Operating Investments =Free Cash Flows Take Present Value (PV) of FCFs discounted by Return on Assets % (also Return on Unlevered Equity %) + PV of terminal value =Value of Unlevered Assets + Excess cash and other assets =Value of Unlevered Firm (i.e., firm value without financing effects or benefit of interest tax shield) + Present Value of Debt's Periodic Interest Tax Shield discounted by Cost of Debt Financing % =Value of Levered Firm – Value of Debt =Value of Levered Equity or APV The value from the interest tax shield assumes the company is profitable enough to deduct the interest expense.
[1] The idea is to value the project as if it were all equity financed ("unleveraged"), and to then add the present value of the tax shield of debt – and other side effects.
[3] APV and the standard DCF approaches should give the identical result if the capital structure remains stable.
The APV method is especially effective when a leveraged buyout case is considered since the company is loaded with an extreme amount of debt, so the tax shield is substantial.