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While calculating APV, we consider the tax benefit of interest cost, but don’t reduce the interest cost cash outflow from earning. Why?
For example:
Invest 100M; Times 1 – 5 Earn 60M p.a. pre-tax; Tax = 30%, paid at the end of each year. Cost of equity (ungeared) = 20% Pre-tax cost of debt = 5%
Finance: 70% equity and 30% irredeemable debtTo calculate the gain to the shareholders, we consider the NPV of ungeared + PV of tax shield. But don’t consider the interest cost on 30M debt (100M *30% finance thru debt). Our cashflow in geared co. (in this example) will be 60M less (30M debt * 5%(1-30%) cost of debt). Why we don’t do the above.
Discounting effectively accounts for the cost of financing, whether that cost is dividends paid (in the case of equity financing) or interest (in the case if debt financing). You do not account for dividends or interest and discount at the same time or you would be double-counting.
The APV adjustment is really reflecting that you can replace some equity funding with debt funding, but because you get tax relief on the interest you can think of it as getting debt finance ‘on the cheap’. 30% tax relief is exactly like the government handing you a subsidy equal to 30% of your interest cost. The APV adjustment calculates the value of this state hand-out.
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@kengarrett said:
Discounting effectively accounts for the cost of financing, whether that cost is dividends paid (in the case of equity financing) or interest (in the case if debt financing).Hi sir, my apologies for hijacking this thread, I would like to query on this as I am confused in this matter. This “double counting” was explained by another lecturer that it is due to in WACC’s computation, where there is a (1 mins T) for debt portion – effectively taken into account for the interest cost. Therefore in the scenario of FCF, we discount using the WACC to derive the PV of the FCF. No interest deduction performed in any part of the FCF, otherwise we would be double counting – understood.
But when you do a APV computation, the discount factor used is the keU (ungeared cost of equity) which consist of no interest component is still treated as there is interest?
If it is so, then computing FCFE we would have been double counting? Because FCFE is achieved by deduction of interest cost, then you have to discount it using KE. This is going by the logic of “discounting” will always “effectively accounts for the cost of financing”.
Your advise will be greatly appreciated.
If a project is all equity financed, all you need to discount by is the cost of equity (ungeared). If the NPV is positive the project is good enough to keep shareholders happy.
If you were to borrow $1,000 at 10% interest, in perpetuity with 0% discount rate, the NPV of the finance is zero:
1000 (received) = 1,000 x 0.1 (the interest) x 1/0.1 (the perpetuity factor) = 1,000 paid.
If the government subsidised your interest payments by letting you off say 30% (the tax rate) then you make a profit because you are effectively paying only 7% when you really should pay 10%.
Received = 1,000
Paid in perpetuity = 1,000 x 0.1 x 0.7/0.1 = 700So a gain of 300 (= t x debt)
APV attempts to calculate the gain arising from the finance.
Not sure if that addressed your query.
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