Please assist on question 5. What is the Base Case NPV? Please see my workings and advise where I went wrong 1.Base NPV $130m 2. (a) Interest on Tax shield = Tax rate x Pre tax borrowing rate x Debt = 0.25 x 0.05 x $200 =$2.5 2.(b) PV of tax shield = Interest Tax Shield / Pre tax borrowing =$2.5/0.05 =$50 3.APV = Base case NPV + PV of tax shield = $130+$50 =$180

The rule is that you always discount the finance flows using the pre-tax rate appropriate to the type of finance. Although the actual finance is at 7%, it really should be at 5%. If you were to discount the cost of the loan at 7% you would not capture its true cost.

It might be easier to see if the actual rate had been 3%. Then you would have to discount the finance flows at 5% and that would result in a positive NPV (even ignoring tax) and that would show that the cheap loan finance gives an advantage.

dhanalakshmi96 says

please provide the answer for question 2

Ken Garrett says

Systematic risk is less than market risk

Asset Beta is less than Equity Beta.

motlanalo says

Hi Gromit

Please assist on question 5. What is the Base Case NPV? Please see my workings and advise where I went wrong

1.Base NPV $130m

2. (a) Interest on Tax shield = Tax rate x Pre tax borrowing rate x Debt

= 0.25 x 0.05 x $200

=$2.5

2.(b) PV of tax shield = Interest Tax Shield / Pre tax borrowing

=$2.5/0.05

=$50

3.APV = Base case NPV + PV of tax shield

= $130+$50

=$180

msj4396 says

In question 5, why are we using risk free rate of 5% instead of 7% which is the actual rate of debt?

Ken Garrett says

The rule is that you always discount the finance flows using the pre-tax rate appropriate to the type of finance. Although the actual finance is at 7%, it really should be at 5%. If you were to discount the cost of the loan at 7% you would not capture its true cost.

It might be easier to see if the actual rate had been 3%. Then you would have to discount the finance flows at 5% and that would result in a positive NPV (even ignoring tax) and that would show that the cheap loan finance gives an advantage.

bwongani says

Hi Gromit,

Am I missing something on question 3. What is the question asking us to calculate

panawala says

If you don’t pass the test …. it does not not show “Review Test” but only shows “Retake Test”

Kindly provide “Review Test” option if one fails.

sherazsarwar says

agreed. This will help to evaluate better

bwongani says

Hi Panawala,

Please go to print you will be able to see the results.