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Hello!
My query is regarding the financing side effects:
1) Under Present value of tax shield on interest payments, we take the gross loan * interest rate * tax rate. So why don’t we compute it this way? [(60%* $42.97m) * 2.5% * 20%] multiplied by annuity factor of 3.808
plus the ([40%* $42.97m] * 1.5% * 20%) multiplied by annuity factor of 3.808.
2)And under subsidized loan benefit, we take the gross subsidized loan * interest savings * (1-T). Again why don’t we compute it this way? (60%* $42.97m * 1.5% * [1-0.2]) multiplied by annuity factor of 3.808.
In short, my workings are totally different to the examiner’s.
Can you please explain where I could be going wrong? and why?Thank you.
From note (v) of the question, the interest rate on normal borrowing sources is 1.5% more than the government yield rate and is therefore 2.5% + 1.5% = 4%.
The subsidised rate is 1% less than the government rate is 2.5% – 1% = 1.5%.
As far as the discounting is concerned, the examiner has discounted at 4%. However he does state in his answer that 2% (as you have used) or 2.5% could be used instead, even though obviously the final answer would be a bit different. I explain the reasoning for there being a choice of rate for the discounting of the tax benefit in APV questions in my free lectures.
Ok…but I don’t get it regarding the subsidized benefit.
This is because as per my understanding, subsidized benefit is the amount which you save i.e the difference between the rate at which you’ll likely to be paying and the rate at which government grants to the company. So in my opinion, the government usually grants a lower interest rate compared to the normal rate, hence likely to create savings for the company.
(Correct me if I’m wrong anywhere).Now as per our Burung case, it says that the company is being lent the money at a rate of 100 basis points (i.e 1%) below the 10 year government debt yield rate of 2.5%.
So isn’t 1% to be used as a subsidized benefit? This is because the 1% is the savings you’ll generate.
Kindly correct me if I could be going wrong.
Thank you.
The saving to the company is the difference between the interest that they would normally have to pay (in this case 4%) and the interest they actually end up paying (in this case 1.5%). (If there wasn’t the subsidy they would have had to borrow at the normal rate of 4%)
Hello Sir,
In regards to Burung, can you please explain to me why the issue cost is calculated as 2/98 X 42,970,000 and not 2% X 42,970,000 and also why tax allowable depreciation was not added back after computing the tax on profit.
Many thanks
1. The project needs an initial investment of $42.97 and therefore the amount they need to raise must be higher than this so that after the issue costs there remains $42.87 available to invest. For every $100 raised, the issue costs will be $2, which leaves $98 available to invest. So the issue costs must be 2/98 times the amount needed to invest.
2. TAD is only added back if it had previously been subtracted in the cash flow statements (because it is not a cash flow). Here it has not been subtracted in the cash flow statements, only in the the calculation of the tax in workings 1, and therefore does not need adding back.
Thank you, the issue costs aspect has been understood now.
When I attempted this question, I incorporated all the tax computation in the cash flow statements, therefore added back the depreciation. I believe it is then correct to add it back since its not a cashflow,
You are correct that depreciation is not a cash flow. Therefore if it had been subtracted in the cash flow statement (and the tax calculated in the cash flow statement) then it would have been added back.
However, in this answer the tax workings have been done separately. Nowhere in the cash flows has depreciation been subtracted and therefore there is nothing to add back in the cash flows.
Hi John – Apologies I’m still struggling with the capital allowance piece though I have watched your lecture and gone through some past papers and would be so thankful for your assistance before the exam this Friday.
For Burung Co, I know you mention that nowhere in the cash flows has depreciation been subtracted so we don’t have to add back the capital allowance. I checked another one of the ask the tutor threads where it was mentioned that in Fubuki we had to add it back in that question. However, when I looked at Fubuki, I can’t see where it was mentioned that depreciation had been subtracted. So now am unsure why we added back tax capital allowance for Fubuki but not for Burung Co.
I also took into consideration your point about how one of the methods of dealing with WDTA is to tax the full amount of the profit and add back the tax saving. When I tried to do this with Burung Co I got stuck. I wasn’t getting the same answers.
Would be so grateful for your help and sorry if I’m being super thick!!
I don’t know where you are finding the answer to Fubuki, but in the examiners own answer the deprecation was not added back because as with Burung, it had not been subtracted in the cash flows (only in the separate workings for the tax).
Also, in Burung, taxing the full profit and adding back the tax saving will not work because there are tax losses. That is why the tax has to be calculated separately.
Hi John – It was in the Bpp kit but realised that they added back the tax saving in Fubuki not the annual tax allowance. If the difference in approach between Fubuki and Burung is because there are tax losses for the latter question, apologies where can I see this in the question or answer for Burung co? The cash flows appeared positive from year 1 for Burung.
Thank you again for your help!
Sorry, ignore that I wrote about losses – I was muddling it with a different past question. Sorry for confusing you.
Either approach would be OK here, but doing the tax workings separately in Paper AFM is safer because sometimes there are tax losses 🙂
No worries 🙂 In that case if either approach is OK would you be able to show an example on how I would get the same answer for year 1 for instance for Burung? Because when I tried to tax the full amount 10.50 x 0.2, I get 8.4 (10-2.1) but adding back the tax saving (0.2 x 8) leaves me with 10. I feel I did something horribly wrong there ha…and wasn’t sure if it was to do with the tax loss point you made.
It looks to me doing the tax working separately appears safer too!
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