194  Frameworks for Valuation
goodwill. If you measure ROIC without goodwill, you must also mea-
sure invested capital without goodwill. All told, it doesn’t matter how 
you define invested capital, as long as you are consistent.
• Use a constant cost of capital to discount projections.
Exhibit 10.14 presents the valuation results for GlobalCo using dis-
counted economic profit. Economic profits are explicitly forecast for three 
years; the remaining years are valued using an economic-profit continuing-
value formula.11 Comparing the equity value from Exhibit 10.4 with that of 
Exhibit 10.14, we see that the estimate of GlobalCo’s DCF value is the same, 
regardless of the method.
The benefits of economic profit become apparent when we examine the 
drivers of economic profit, ROIC and WACC, on a year-by-year basis in 
Exhibit 10.14. Note that the valuation is contingent on returns that exceed the 
EXHIBIT 10.14  GlobalCo: Valuation Using Discounted Economic Profit
$ million, except where noted
Year
Invested 
capital1
ROIC,1 
%
WACC, 
%
Economic 
profit
Discount 
factor 
at 7.8%
Present value of 
economic profit
Year 1
348.0
17.2
(7.8)
32.9
0.928
30.5
Year 2
410.0
16.8
(7.8)
37.0
0.861
31.9
Year 3
456.5
15.9
(7.8)
36.8
0.798
29.4
Continuing value
701.8
0.798
560.3
Present value of economic profit
652.0
Invested capital including goodwill1
348.0
Value of operations
 
1,000.0
Nonoperating assets
 
 
 
 
–
Enterprise value
 
 
 
 
1,000.0
Less: Value of debt
(250.0)
Less: Value of noncontrolling interest
–
Equity value
750.0
1 Invested capital measured at the beginning of the year with goodwill and acquired intangibles.
11 To calculate continuing value, you can use the economic-profit-based key value driver formula, but only 
if RONIC equals ROIC in the continuing-value year. If RONIC going forward differs from the final year’s 
ROIC, then the equation must be separated into current and future economic profits:
Value
IC
IC
ROIC
WACC
WACC
PV Economic Profit
WACC
t
t
t
t
t
=
+
−
(
) +
(
)
+
+
1
2
−g
Current Economic Profits
Future Economic Profits
such that: 
PV Economic Profit
NOPAT
RONIC
RONIC
WACC
WACC
t
t
g
+
+
(
) =




−
(
)
2
1
For more on these and other continuing value formulas, see Chapter 14.

Adjusted-Present-Value Model  195
cost of capital but drop over time as new competitors enter and put pressure 
on operating margins. Explicitly modeling ROIC as a primary driver of eco-
nomic profit prominently displays expectations of value creation. Conversely, 
the FCF model fails to highlight when a company creates and destroys value. 
Free cash flow combines ROIC and growth, two critical but very different 
value drivers.
Also note how GlobalCo’s high ROIC—double its cost of capital—leads to 
an operating value that exceeds the book value of its invested capital ($1 bil-
lion versus $348 million). When investors believe a company will create value, 
enterprise value will be greater than invested capital.
Adjusted-Present-Value Model
When building an enterprise DCF or economic-profit valuation, most invest-
ment professionals discount all future flows at a constant WACC. Using a 
constant WACC, however, assumes the company manages its capital structure 
to a target debt-to-value ratio.
In most situations, debt grows with company value. But suppose the com-
pany planned to change its capital structure significantly, as in a leveraged 
buyout. Indeed, companies with a high proportion of debt often pay it down 
as cash flow improves, thus lowering their future debt-to-value ratios. In these 
cases, a valuation based on a constant WACC would overstate the value of the 
tax shields. Although the WACC can be adjusted yearly to handle a changing 
capital structure, the process is complex. Therefore, we turn to the most flex-
ible of valuation models: adjusted present value (APV).
The APV model separates the value of operations into two components: the 
value of operations as if the company were all-equity financed and the value of 
tax shields that arise from debt financing:12
Adjusted
Present Value
Enterprise Value as if the
Company Were All-
=
Equity Financed
Present Value of
Tax Shields
+
The APV valuation model follows directly from the teachings of economists 
Franco Modigliani and Merton Miller, who proposed that in a market with 
no taxes (among other things), a company’s choice of financial structure will 
not affect the value of its economic assets. Only market imperfections, such as 
taxes and distress costs, affect enterprise value.
When building a valuation model, it is easy to forget these teachings. To 
see this, imagine a company (in a world with no taxes) that has a 50/50 mix 
12 This book focuses on the tax shields generated by interest expense. On a more general basis, the APV 
values any cash flows associated with capital structure, such as tax shields, issuance costs, and distress 
costs. Distress costs include direct costs, such as court-related fees, and indirect costs, such as the loss of 
wary customers and suppliers.