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Hi sir,
I have given the portion of the ans from the study hub below. Here they only took the tax benefit lost on int saved on subsidy loan when they calculated the tax shield of both bank loan and subsidy loan @ bank loan int. Why is that.We normally find out tax shield on subsidy loan @ subsidy int rate and will also find the tax benefit lost.
Tax shield
$5,050,505 8% bank loan: $
Annual interest $404,040, tax relief at 30% = 121,212
$4 million 6% subsidised loan:
Annual interest $240,000, tax relief at 30% = 72,000
Total annual tax relief = 193,212The present value of this tax saving, discounted at the company’s commercial pre-tax cost of debt of 8% is: $193,212 * 6.71 = $ 1,296,452?
Alternatively, the full value of the tax shield at the full cost of debt can be calculated as
?($5,050,505 + $4 m) * 8 % * 30% * 6 .71 = 1,457,493?
Value of subsidy
The company saves 2% per year on $4,000,000 = $80,000. The the tax calculation above used the subsidised loan rate, so has already allowed for the tax shield.
Discounted at the company’s commercial pre-tax cost of debt, 8%: $80,000 * 6.71 = $536,800?
Alternatively, if the tax shield was on the entire debt at 8%, the value of the subsidy would also allow for the lost tax shield, so:
?( $4 m * 2% * (1 – 0 .3)) * 6 .71 = $375,760?
APV
The adjusted present value is estimated to be:
? ($790,500) – $467,172 + $1,296,452 + $536,800 = $575,580?
If the alternative approach was taken, the APV would be:
?($790,500) – $467,172 + $1,457,493 + $375,760 = $575,581
The benefit of the tax shield can either be discounted at the normal pre-tax cost of borrowing or at the risk free rate – the examiner always allows either even though obviously the final answer is different. (I explain the logic for each of the two rates in my free lectures on this.)
In this question they have used the normal pre-tax cost of borrowing (8%) (and had no choice anyway since we are not told the risk-free rate).
Therefore all of the tax savings have been discounted at 8% (the fact that there is a subsidised loan makes no difference to the discount rate used).
As the answer shows, when there is a subsidised loan then you can either calculate the tax saved on the actual borrowings at the actual rates (and then discount at 8%) and bring in the full subsidy, or alternatively you can calculate the tax saved as though the whole amount was borrowed at the full rate and then bring in the subsidy net of the tax saving that is lost (again then discounting everything at 8%).
Both approaches end up giving the same result.
So if we are calculating the tax saved on int paid on subsidised loan at actual subsidy rate then do we not have to calculate the tax saving lost and net it with the int saved.
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