Valuing a Leveraged Buyout: Expansion of the Adjusted Present Value by means of Real Options Analysis

A major flaw in using the adjusted present value (APV) method to value the target firm of a leveraged buyout is that it results in systematic undervaluation of the firm in question. The author proposes to remedy the problem by employing real options analysis to expand the target firm's APV on its equity side. Two real options may be identified as being inherent in the leveraged buyout structuring process: a financial default call option and an operating default call option, both of American type. The resulting expanded equity value allows for the flexible management of firm value uncertainty while continuing to incorporate the extra value creation deriving from the exploitation of the tax shield.