We use the adjusted net present value approach to
determine the value international projects.
We begin by looking at the present discounted value of
But we make some adjustments.
Step 1: Calculate the net present value of the project’s cash
flow under the scenario that all projects are financed through
This is the sum of all discounted expected future
revenues minus the sum of current and discounted expected
Revenues and costs are measured on an after-tax cash-
They are measured in the same currency.
They are discounted by a rate that reflects the time value
of money (the riskless interest rate) and the risk premium
demanded by the firm’s equity holders.
Step 2: Add the value of financial side effects.
Costs of issuing securities.
Taxes or tax deductions associated with different types of
Costs of financial distress.
Subsidized financing from government.
Step 3: Value the growth options.
Undertaking a project may open an option to do further
Could be included in Net Present Value, but we separate
1. It is hard to value.
2. It is always positive, so if the project is valuable just
based on steps 1 and 2, it is also worthwhile once we add in
the value of the growth options.
Deriving the NPV of Free Cash Flow
There are several steps in this derivation. One of the
trickier steps involves properly valuing the present value of
taxes on the project.
We want to measure the present value of incremental
profits from the project. The point here is that we want to
count the incremental increase in the firm’s revenue from
undertaking a project. A new project might cannibalize a
previous operation of the firm. We care about the net
addition to the firm’s profit.
Again, we are valuing the project first as if it were
completely financed with equity. So we don’t want to
consider at this stage any tax benefits or costs from
financing by borrowing.
Revenues: Estimate the future revenues from a project.
Include projections of the exchange rate, so that we get the
revenues in dollar terms.
Subtract costs. These costs include the costs of the raw
materials and the labor costs. These are called costs of
goods sold (CGS). Also we need to subtract off managerial
expenses, advertising and fixed costs of the project. These
are called selling and administrative expenses (SGA).
Finally, we subtract off the accounting cost of
depreciation expense. This is not a true cost, but we are
doing this to get our measure of expected earnings before
interest and taxes (EBIT), which will form the basis upon
which taxes are levied.
EBIT = Revenue – CGS – SGA – Accounting
Then we calculate taxes and subtract them from EBIT to
get “net operating profit less adjusted taxes” (NOPLAT).
So NOPLAT = EBIT – Taxes on EBIT
But then we add back in the accounting depreciation,
which wasn’t a true cost, to get Gross Cash Flow (GCF).
So GCF = NOPLAT + Accounting depreciation
Then to get Free Cash Flow (FCF), we need to subtract
off actual investment expenses. These are capital
expenditure (CAPX) and the change in net working capital
(ΔNWC). CAPX includes the firm’s purchases of additional
property, plant, or equipment that is required for the project.
FCF = GCF – CAPX - ΔNWC
We then use the Net Present Value (NPV) formula:
∞ E FCF t k
NPV (t ) = ∑
This formula assumes a constant discount rate, but in
general we may want to let the discount rate vary from
period to period.
The present value formula goes on to infinity, but
obviously we are not going to calculate FCF for an infinite
number of periods. Instead, we will calculate a Terminal
Value for the project. Suppose year T is the last year that
we calculate an expected FCF. We can then calculate the
terminal value in year T using the perpetual cash flow
E [FCF(T ]
) (1+ g)
Terminal value in year T =
r − g
Then to get the expected terminal value at time t, we
need to discount the terminal value at time T back to time t:
E [FCF(T ]
) (1+ g)
Terminal value at time t:
r − g
(1+ r )T −t