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Dear Sir,
On Part (a)-net present value calculation, I need your assistance to figure out the followings:
(1) How did the cost of financing of $16.32 derive?
(2) What discount rate was used to derive the present values of tax shield on interest? I can’t arrive at the numbers based on a discount rate of 7.2%.
Thanks and appreciate your help.
Sorry Sir, the question I referred was in fact June 2008 instead of Dec 2008 as stated earlier. Sorry for the typo.
hi there,
for ur very first query regarding cost of finance 16.32
finance required 800 .. transaction cost ( cost of finance ) is 2%
what amount of finance will you raise to get exact 800 for project = 800/0.98 = 816.32
so 816.32 – 800 is 16.32 which is cost of finance 🙂
and for ur second question regarding discounting of tax savings 7.2%
so its LIBOR + 180 basis points = 5.4 % + 1.8% = 7.2%
Libor = 5.6% ( given ) and 100 basis points = 1 % in question it was 180 basis points so 1.8%
i hope it helps you but u can wait for tutors reply.
Muneebnawaz is correct regarding the amount of finance needed.
With regard to the discounting of the tax savings, the examiners answer is terribly confusing (thankfully this was the previous examiner – not the current one).
What he has done has discounted at LIBOR of 5.4% (despite what he wrote below his workings) on the assumption that it is risk free. Because the tax is one year in arrears, he has discounted the time 1 tax on interest for 2 years, the time 2 tax on interest for 3 years, and so on.
Whether you discount at risk free of 5.4% or at the rate on debt of 7.2% does not matter – there is an argument for both, and you get full marks using either.
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