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Hello Ken,
This question comes from P3 Exam practice kit.
What I do not understand is the handling of tax shield and subsidy in the calculation of adjusted present value.
I understand the subsidy calculation is to calculate the interest cost saved and the associated tax shield lost.
I have a fundamental question about APV
1. . Why we do not need to calculate the interest cost incurre, after the base NPV is identified?
Because I assume you calculate the base NPV as if it is all financed by equity. And then we calculate the cost and benefit due to decision of financial package.2. Why do we need to calculate the interest cost saved due to subsidy?
I thought it should be considered as a second loan with the interest incurred.
thanks,
KennethQ255:
Bohemian Subsidy Co are based in the US, they are currently all equity financed and are
looking to take advantage of debt financing for a new venture they are looking into. The
discount rate the firm currently uses is 14%.
The machine that they are considering purchasing would cost $10,000,000 and lead to cash
inflows of $800,000 for the next 15 years.
They will obtain finance of $6 million from a government subsidised loan at a rate of 3%,
with the remainder at the general market rate of 10 %
The Issue costs on the debt finance will be in total $500,000.
The tax rate is 22%
Bohemian Subsidy intends to use an adjusted present value calculation.
What is present value of the financing?.
$______________Answer:
2,962,251.20Tax relief on debt interest
$ $
Interest – market rate debt 6,000,000 0.03 180,000
– Government subsidy 4,000,000 0.10 400,000
Total annual interest 580,000
Tax saving/year 580,000 0.22 127,600
PV of tax saving 127,600 7.606 970,525.60
Value of the subsidy
$ $
PV of Interest saved 6,000,000 (0.1-0.03) × 7.606 3,194,520
Less PV of tax relief lost
6,000,000 × 0.07 0.22 × 7.606 -702,794.40
2,491,725.60
Issue costs 500,000
PV of financing = 970,525.60 + 2,491,725.60 – 500,000 = 2,962,251.20Q1 Correct. It is not so much the interest that is important but the tax subsidty which means that you get finance on the cheap. Tax relief is like you are paying interest at the normal rate but then the government hands you money in the shape of tax relief.
Q2 The lowering of the tax rate from 10% by 3% is like paying interest at 10% then you being handed back 3%. However your benefit is not 3% because you do not get tax relief on that 3%: it’s not all ‘made money’.
That’s why in the calculation the lost tax relief has to be subtracted from the finance benefit.
HTH. Come back if you need more.
Hi Ken,
I have passed the P3 and F3!! Now in the preparation for the last SCS in coming November. A huge thank you for the support by y ou and Opentuition!
A zillion of thanks!
Kenneth
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