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In this que while calculating the financing effects, the amount of loan should be 42.97m + .876m (issue cost) and then the annual tax shield should be calculated. Because we would require 42.97m for project financing and if out of this amount I pay issue cost of .876m then the amount available for project will be less.
In the text book of Kaplan in test your understanding 2, they have calculated annual tax shield after adding issue cost.
I have this same doubt in que Fubuki Co (dec 10) in this also amount of loan is not taken including issue cost.
The tax shield is always calculated on the amount of debt finance that is actually raised.
The issue costs could come from one of two places. They might be paid out of the debt raised, in which case the debt raised is the amount needed for the investment as grossed up by the issue costs. Alternatively the issue costs might be paid from existing cash balances, in this case the debt raised is equal to the amount needed for the investment.
Often in the exam it is not clear which of the two applies. In that case make an assumption and state your assumption. You might assume differently than the examiner, but you would still get the marks (provided that, as always, you state your assumption). It is rarely in Paper AFM that there is only one correct answer because so many questions depend on assumptions which is why it is always essential to state your assumptions.
Thanks a lot for clearing this.
I have one more doubt in this que.
What does the line ” it can be assumed that the debt capacity available to co is equal to amount of debt finance raised for the project” mean?
Does this have any relation with the previous doubt that what assumption we should take?In theory the tax shield should be calculated on the debt that they are able to raise rather than the amount actually raised at the moment. However we assume (even if the question had not said it) that the two are the same.
Sir, in this question, I am not able to figure out why they have taken the asset beta of the proxy company to compute Ke from CAPM model.
Isn’t equity beta used in the CAPM model
The equity beta is used to calculate the cost of equity. However the equity beta depends on the risk of the business (which is measure by the asset beta) and the level of gearing (which is accounted for using the formula).
Have you watched my free lectures on this? 🙂
Yes sir, I watched the lecture again, I understood now.
Sir I have another doubt regarding issue cost. I am not able to understand when issue cost is to be included and not, in the funds raised for tax shield calculations in APV.
Can you please explain that to me sir?
It depends on the wording of the question. If it is not clear from the wording then state your assumption and you will still get the marks 🙂
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