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Hello Mr Moffat,
Regarding calculation of tax shield, assuming we are given to evaluate a project, and the future cash flows given is 4 years. However the bond expires after 7 years. Which one should we use in relation to computation of tax shield, 4 or 7? (BPP Q72 Intergrand SFM, 12/02 )
Thanks
I think i realised my mistake , kindly correct me if am wrong. In the question it didn’t exactly say that the project is worth 4 years, so in that sense we will assume the project is a going concern so the tax shield will be based on 7 years of the Bond. But lets say a project is worth 4 years and the bond is 7 years. My 1st question is it possible to have such combination, and my second question is , if it is possible to have such, then the tax shield will be based on 4 years right?
Mr Moffat forgive me asking too many questions.
Thank you very much.
If it is doing the project that gives rise to the ability to raise more debt, then the tax benefit on the debt is for the ‘life’ of the debt.
Sir,
When we value a target company using APV method we should calculate FCFF and then to discount it using ungeared cost of equity of the aquisition company?
So I am not sure which cash flow to calculate in APV valuation FCFF or FCFE? and why
Could you please also explain how the examiner calculated value of the loans?
do not take market value of bonds(1230) and that is all. I also do not understand where did fugures(exept market value of bonds 1230) for bond calculation did come from… I mean 30,
1000, 18You take the free cash flows to the firm. (Which, if you think about it is the same anyway as the free cash flow to equity if there was no gearing 🙂 )
In fact part (a) of the question specifically tells you to do this anyway.Usually we take the free cash flows and discount at the WACC. With APV we take the free cash flows and discount at then ungeared cost of equity (and then add on the tax benefit from the debt).
With regard to the value of the debt, if you look at the Statement of financial position given in the question, there are bank loans of 30.0 (and bank loans always have the same market value as what appears in the statement) and also bonds with a nominal value of 18.0. Note 5 says that the market value is 1,230 ( obviously per 1,000) and so the total market value of the bonds is 1230/1000 x 18.
Thank you!)
I understood it as follows:
When we value company using APV method we can either:1) Calculate FCFF
-discount it using ungeared cost of equity,
-substract market value of debt. -and account for side effects2) -Calculate FCFE
-discount it using ungeared cost of equity,
-and account for side effectsRight?
Debt calculation is absolutely clear for me now.
Good point that fcff and fcfe are equal for ungeared company. Did not think about it before…
I also think it make sense to use avp only for geared company or for the company which financial risk is greater than the financial risk of aquirer. I think this question does not explicitely indicate that it is type 2 aquisition. And financial risk is different but business risk is the same…
No. With APV you discount the free cash flows at the ungeared cost of equity and add on the tax benefit of the debt.
There are not alternatives.
APV is a better approach than just discounting at the WACC when there is a large change in the gearing.
This question specifically tells you to use an APV approach.
Sir, why do we calculate tax shield on bank loan in so strange manner:
30×0.25 = 7
Shouldnt tax relief be calculated on interest expense but not on principal amount?
Yes, and it will come to exactly the same figure.
We don’t know the interest rate on the loans, but just suppose it is (say 5%) and suppose it is irredeemable (although that makes not difference).
Then the interest is 30 x 0.05 per year
The tax relief is 25% x 30 x 0.05 per yearTherefore the PV of the tax saving is 25% x 30 x 0.05 x 1/0.05, which is the same as the answer.
(The same happens even if it is repayable, because loans are never repaid at a premium)
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