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Why do I use the pre tax cost of debt to calculate the tax shield on a subsidised loan? For example
Tax shield – calculate tax pa (using subsidised rate), then calculate tax saving pa on this answer, then use the company’s pre-tax cost of debt to calculate the AF to find out the tax shield. Why not use the subsidised rate to find AF?
I could just take this as a given, but if I understand why I’m doing it I’m more likely to remember.
Thanks
I have just been for a walk to think this one through. Could someone correct me if I am wrong or confirm my assumptions please
Do we use the company’s pre-tax cost of debt for two reasons
1. Because we are calculating the saving of interest ie difference between what we should have paid and what we end up paying.
2. The original calculation will have been based on all equity, so the DCF will be for equity only, not subject to tax. As we are only calculating the discounted value of the money we now don’t have to hand over to the tax man, we should use the cost of debt as it is what the company would pay and its pre-tax as it would be for all equity?You use pre tax cost of debt as the tax shield is the savings made from the use of debt finance ie the tax savings. Use of debt means that the company beenfits from tax relief, where using equity the company does not
Assuming you are looking at APV, the concept behind APV is to show the benefit of using debt to finance an investment over straight forward equity, part of this is the tax saving made
The fact the loan is subsidised just reduces the amount that the company is taxed on, they still have to pay tax on the unsubsidised part, its just there is a ‘tax free’ balance that you need to consider
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