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Good Evening!
I am doing Q#25 from the latest bpp kit. one complication is that of a subsidy.
we are given 4 rates:
1) 2% risk free rate (treasury bills)
2) the normal cost of debt on which the company usually borrows, which is 150 basis points above the “10-year govt debt yield rate”, which is 2.5%. the company’s usual borrowing rate is therefore 4% (2.5+1.5).
3) the “10-year govt debt yield rate”, which is 2.5%
4) the subsidy rate is 100 basis points below the rate in (3) thus it is 1.5%
the 2% treasury bills rate is given in the context of another co, Liftu which has all the data to calculate ungeared Ke.
and there are 2 loans: one is at the subsidized rate and the other at the the usual borrowing rate
first question: in calculating PV of tax shields on these loans, i discounted using the risk free rate of 2% but the answer uses the “10-year govt debt yield rate” of 2.5%.
i thought tax shields are done at risk free rates..can u pls explain.
second question: in calculating the savings on the interest rate he does
savings = debt x (4-1.5) x 80%
(tax rate is given 20%)
i dont understand where the 80% is coming from? if it is related to the tax rate.. how is it related??
regards
There are arguments for discounting at either the cost of debt (which here is 4%, not 2.5%) or at the risk free rate, and the examiner accept either (even though obviously they result in a different answer).
The 80% is to calculate the subsidy benefit net of tax at 20%.
thank u sir
You are welcome 🙂