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When we use the Base NPV to calculate the APV, we will add back the PV of the issue cost on debt finance & equity finance then we will less the “TAX SHIELD”
I can’t fully understand how to calculate the “TAX SHIELD”, is there anyone can share the idea?
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Hi Kennyedith! Your question is interesting. APV is based on 2 decisions;
Investing Decision (assuming project is all equity financed) and;
Financing side Effects of the appraisal claculated and added up to get APV.
Your question relates to the financing side effects. Its composition is issue costs, subsidies, tax shield on debt interest, cheap loans etc. So, issue costs are not added back to Base NPV but subtracted as they constitute a cost to the company and consequently the project in question. Adding it back to BASE npv would inlating that figure and ending up with a wrong figure and of course a wrong decision as it would been otherwise.
mbaw- Topics: 0
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the tax shield could be called also “tax savings” and in investment appraisal, this constitues a cash inflow generated from capital allowances due to investing in tax allowable capital expenditure (CAPEX).
Under the APV technique then, savings would normally increase Base NPV. So it tax shields normally should added back to it. However, where the company had a choice to take advantage of such savings or not and it chooses the option which does allow it to gain such tax advantages, this becomes an opportunity cost to that particular project and may then lead to you subtracting the ‘Tax Shield’ from the base NPV. Without that , tax shields are savings and should always increase or improve base Npv.
mbaw- Topics: 1
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mbaw,
Yes, you are correct we should substract the issue costs from the base NPV and then adding back the TAX SHIELD. I am sorry for my careless question asking.
Thanks for your explanation, and it really help me a lot,
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u are always welcomed Kenny. those things always happen like that. why cant u join zuzana and I in the study buddy for p4 and p5? we are about coming up with a time schedule for that
i dont understand why i never took advantage of such an opportunity last sitting.kindly include me.i failed this paper last time because i did not understand it at all.i think i am now getting the understanding.kindly include me as part of the study buddy.i live in ny.unfortunately i have to study on my own.this my final paper.
on subject on Apv I have been working through apv question 5 Neptune June 2008 acca exam. Any ideas how they get the discounted value of tax shield 71.63 with workings please. Appreciate advice. Thanks!
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The additional debt needed to raise to cover the $800m initial outflow after allowing for the 2% issuing cost: $800m/98% = $816.33m
The prevailing borrowing cost of Neptune: 5.4% + 1.8% = 7.2%
The tax shield thereon: $816.33m x 30% tax rate x 7.2% = 17.63m per annum.
Hi thanks. I understood that part I just don’t undertand the discount rate to get from 17.63 to 15.87 in yr 1 etc = total discount value of Tax shield 71.63.. Thanks
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As the tax was paid one year in arrear, Year 1 tax shield of $17.63m has to be discounted by the 5.4% LIBOR rate twice, i.e. 17.63m/1.054^2. Year 2 tax shield will be discounted by 3 years and so forth.
Thanks very much for your responses. That makes sense now although would have helped if they put this in the yr 2 working and I thought it should be 7.2% as per the answer not libor but hey although I was thinking they got 10% discout from somewhere. This exam is a worry! Revision course next week will help a homestudy is tuff!
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7.2% must be wrong because the risk of a tax shield must be lower than that of Neptune.
@sosologos said:
7.2% must be wrong because the risk of a tax shield must be lower than that of Neptune.I don’t really understand what you mean.
The risk associated with the tax shield is the same as the risk attaching to the loan interest (because the tax saving depends on the interest paid).
Since the risk attaching to the debt interest is 7.2% (that is the return the investor wants – not the actual cost to the company because the company gets tax relief), we therefore discount the tax savings at 7.2% as well.- Topics: 0
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APV is a more sophisticated appraisal technique because it admits the fact that a project may involve mixed risk level cash flows (i.e. the ‘variation of components rule).
However, John’s logic drives me to figure out an interesting case. Each cell phone model matches to a dedicated battery model. I assume that the risk associated with the production of cell phone is higher than that of producing a battery. If firm A produces the cell phone and firm B produces the battery. Firm A risk level should be higher than firm B’s. Now, firm A wants to produce the battery internally. Could we say that the risk level of battery will become the same as that of the cell phone now just because the battery is attaching to the cell phone?
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