Adjusted Present Value is used in evaluating foreign project. The adjusted present value model is additive approach to capital budgeting process .
In brief, each cash flow is considered individually & discounted at a rate consistent with risk involved in the cash flow.
Further, different components of the project’s cash flow have to be discounted separately.
The adjusted present value method uses different discount rates for different segments of total cash flows depending on degree of certainty attached with each cash flow. The financial analyst tests the basic viability of the foreign project before accounting for all complexities.
Further, if the project is feasible no further evolution based on accounting for other cash flows is done. If not feasible, an additional evolution is done taking into consideration the other complexities.
The Adjusted Present value is represented as follows:
-I0 + ∑ Xt /(1+K* )t + ∑ Tt /(1+id )t+ ∑ St /(1+id )t
Where,
I0 = Present value of investment outlay
Xt /(1+K* )t = Present value of operating cash flow
Tt /(1+id )t = Present value of interest tax shields
St /(1+id )t = Present value of interest subsidies
Tt = Tax savings in the year t due to financial mix adopted
St = Before tax value of interests subsidies (on home currency) in year t due to project specific financing
id = Before tax cost of dollar dept (home currency)
The initial investment will be net of any ‘Blocked Funds’ that can be made use of by the parent company for investment in the project.
‘Blocked Funds’ are balances held in foreign countries that cannot be remitted to the parent due to exchange control regulations. These are direct blocked funds. Apart from this, it is quite possible that significant costs in the form of local taxes or withholding taxes arise at the time of remittance of the funds to the parent country. Such ‘Blocked funds’ are indirect.
Moreover, if a parent company can release such ‘Blocked Funds’ in one country for the investment in a overseas project, then such amount will go to reduce the ‘Cost of Investment Outlay’.
The last two terms are discounted at the before tax cost of debt to reflect the relative cash flows due to tax and interest savings
