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Im not sure why using 5% interest rate of borrowing USA to be discounted rate to cal. tax shield and subsidy benefit?
Can i use 13% to be discounted rate ? my reason is the normal interest rate of borrowing Gamala. so i use it to pv .
And the question state Tramont co can borrow dollar funds at interest rate of 5%, why Tramont not borrow the fund in home country that interest rate is lower than Gamala govt subsidized interst rate (6%), and also the corp tax rate is 30% in USA, so the tax saving of the interest payment should be more than borrowing the loan in Gamala.
Do i need to cal the difference of the loan interest between both countries and add to opportunity cost in the question?
thank you very much and appreciate.
Not 13%.
However, it really comes down to assumptions.
The tax shield should be discounted at the rate relevant to the ‘riskiness’ of the borrowing.
As the examiner says in his answer, you could therefore use their borrowing rate of 5% or the risk free rate of 3%. There would also be an argument for using the subsidised rate of 6% and I am sure that the examiner would have allowed this as well (provided that within your report you stated the assumption relating to whichever rate you ended up using).Why does the tax shield and subsidy benefit both use 20% tax rate to calculate? Is it because the fund is borrowed in Gamala that’s why it’s using Gamala’s tax rate or is it because the project is taken place in Gamala?
Also, to calculate base case NPV, the cash flows have to be discounted at ungeared cost of equity but why is the cash flow in Tramont not discounted at ungeared cost of equity but at their own COC?
It is Gamala’s tax rate because the interest will reduce the taxable profit in Gamala and therefore save tax at Gamala’s tax rate.
The cash flows have been discounted at 9.6%, which is the ungeared cost of equity appropriate to the project.
@johnmoffat said:
The cash flows have been discounted at 9.6%, which is the ungeared cost of equity appropriate to the project.the cash flows generated in Gamala is discounted at ungeared cost of equity but the cash flows in USA is discounted at COC.. why?
APV is relevant for the Gamala flows because the finance is raised from debt. For the USA flows, there is no change to the financing within the USA and so the cost of capital is more appropriate.
Hi.
I have 2 questions.
1) why is the PV of tax shield and subsidy not done in Gamala and then converted to current spot rate of 55. but it is done for 4 years, converted each year to dollar, then discounted.
that is..(first method)
tax shield = 270*0.06*0.2*3.546 =11.489 ( i have used 5% for 4 years annuity as 3.546)
tax subsidy = 270*.07*.8*3.546 = 53.615Total = 11.489+53.615 = 65.104
convert to $ = 65.104/55 = 1.184 million $but text book answer with other method is 1.033 million $
(the difference is marginal though)
can you tell me why 2nd method is used over 1st method. and also when do we use 1st and when do we use 2nd method. for the apv + international problems
the second question…
2) The question mentions the loan need not be repaid if 4 years operation happens. assuming it does, what is the effect of giving free loan? the initial investment will be zero. since we are not spending any money out of pocket as investments. and we wont have to pay in future.
The answer to both questions is related in that whether the investment is worthwhile or not depends on obviously the cash flows but also the level of risk of the investment.
With an APV approach, the business risk involved is accounted for by discounting the flows at the all equity discount rate. As per M&M, if there were no tax then there would be nothing else to do because gearing would make no difference. However with tax, M&M state that there is the extra benefit due purely to the tax relief on the debt interest, which is what we are adding on to the base case NPV when using an APV approach.
As far as your first question is concerned, the gearing effect on Tramont depends on the $ interest payable each year which is why we always take what you have called the ‘second method’. (Although you would still get most of the marks doing what you want to do, even though it is not strictly correct).
As far as your second question is concerned, it is not actually a free loan in that there is interest payable regardless of whether or not the loan has to be repaid at the end of four years. Wherever the initial money for the investment is coming from, the decision depends on whether or not the returns from the investment are sufficient to make it worthwhile investing in this particular project – i.e . do the returns compensate for the risk involved.
Thanks for your reply. I am fully satisfied with respect to my 1st question. with respect to my second question. I agree it is not ‘free’ loan. since interest has to paid. I like to rephrase my second question.
how will the calculation change and therefore the investment decision change, if the loan has to be repaid in 4 years from the loan doesn’t have to repaid at all. surely the 270 million GR affect our investment decision in this case. it is more like government grant.
Normally, we assume that borrowings have to be repaid and if that were the case the flows would be just as in the examiners answer.
Here, the fact that the part of the borrowing will not be repaid would be treated as though there was a receipt of that amount at the end of 4 years (it is not a cash receipt but it is an opportunity saving because there is not a payment of that amount).
If you had included a cash inflow of that amount at time 4 you would still have got the marks. However the examiner has assumed that since the production rights will be sold to a government backed company, then the proceeds of 450 million effectively include the cancellation of the loan.
Because this is simply an assumption, the examiner really should have stated this as one of the assumptions in the report.
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