APV subsidy benefit

It is because we have already taken 25% of the interest (as tax relief). So when we look at the subsidy we can't take the interest benefit again so we only look at the remaining 75%.

Dear sir, Relate to above old matter, the example of subsidy in BPP text as follows: A $6 million 4 year-project is financed by government loan @ 10%, instead of normal loan @ 12%. Rf=6%. Tax rate 30%, payable late 1 year. In their solution, they calculate the effect of cheap loan as: + Effect of tax shield: 6m x 10% x 30% x Discount factor @ 6% (Year 2 - 5) = $588,420 + Effect of cheaper loan: 6m x (12% - 10%) x Discount factor @ 6% (Year 1 -4) = $415,800. The confusing problem is: my fellow using Kaplan Text said that we also need to account the effect of tax shield loss due to cheaper interest, which = 6m x (12%-10%) x Tax rate x Discount factor @ 6% (Y2-5). I also feel that is more proper. So what solution is correct?

There are two ways of arriving =at the same end result. Either take the tax benefit on the actual interest paid (in your example 10% x 30%) and add on the full subsidy (in your example 2%). Ignoring the discounting, this gives a total benefit of 5% (and is the way that BPP has done it). Alternatively, take the tax benefit on the normal interest (in your example 12% x 30% = 3.6%) and then take the subsidy net of tax (in your example 2% x 70% = 1.4%). Again the total benefit is 5%. (Are you sure you read the Kaplan text correctly) Some past examiners have done it one way and some have done it the other way, but the current examiner does it the first way (although either will get the marks).

I am not sure I understand the Kaplan example correctly :). Hence, here is the example my friend copied from his Kaplan text (I summarized a bit): " A PLC requires 1m in debt finance for 5 yrs: 700,000 in the form of 10% debentures, redeemable in 5 yrs, the remainder under a government subsidised loan scheme at 6%. Tax rate 30%, delayed 1 year. Kaplan solution: (a) PV of tax shield: = (700 x 10% x 30% + 300 x 6% x 30%) x Discount factor @ 10% (5 years) x DF 1 year. (Kaplan says: although the cheap loan costs 6%, it has the same risk as a normal loan, then appropriate discount rate is 10%). (b) PV of the cheap loan: + Interest saved = 300 x (10% - 6%) x DF 5 yrs @ 10% + Tax relief lost = -(minus) 300 x (10% - 6%) x DF 5 yrs @ 10% x DF 1 yr @ 10% Kaplan solution really makes me confused :)

Kaplan's solution is OK - they have done it the second of the two ways that I wrote in my previous reply. As far as the discount rate is concerned, you can either discount at the cost of the loan (as Kaplan has done) or the risk free rate. It is arguable as to which is the better, but the examiner always allows either (even though obviously the answer will be different). (The argument is as to whether the tax relief on the interest carries the same risk as the loan or is risk free - in a perfect world the two would of course be the same :-) )

Thank you for your time, but sadly I still not really got the idea. Ignoring all discount rate, as the solution of BPP, they include 2 things: (1) tax effect of the actual interest paid and (2) effect of reduction in interest (not tax effect of it). But the solution of Kaplan adds 3rd effect: (3) tax effect of reduction in interest (Tax relief lost = -(minus) 300 x (10% – 6%) x DF 5 yrs @ 10% x DF 1 yr @ 10% x Tax Rate (30%), I forgot this tax rate in the formula in the previous post) I don't see this effect in the solution of BPP. So I think there must be difference in the result?

Sorry - I was wrong in my last reply. Kaplan should not have brought in the tax relief lost (because they had calculated the tax relief on the actual interest paid). My earlier reply was correct :-)

OK, thank you sir. You have saved me a lot of time! I just cannot believe there is such difference between the 2 largest text book providers!

You are welcome :-)