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Hi John,
In most APV questions, we often have a choice of discounting tax savings using either cost of debt or risk free rate or something else that I am not aware of yet. However I am not really sure what are the underlying assumptions when we use a certain rate for discount, what are the reasons for using a certain rate. The answer will require us to state the assumption in exam so that I wonder if you can help explain the reasoning/assumption underlying different choice of discount rate for tax savings?
Another thing is when calculating market value of debt, if the question does not state the credit risk of the debt for us to specifically calculate cost of debt, then which rate should we use to discount the cash flows of the debt to calculate market value of debt? Is that risk free, or coupon rate, or something else and what is the underlying reason/assumption for each rate type?
Thank you.
In APV, you can either discount the tax shield at the risk free rate or at the return on debt. There are good arguments for both, and the examiner always accepts either.
I explain the arguments in my free lectures on APV, but you are never expected to explain them in the exam.
With regard to the market value of debt, the flows should always be discounted at the investors required rate of return. There will always be information in the question enabling you to decide what that required return is.
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