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hello sir,there are 2 things i dont get from the solution of the examiner,
1. from what i know we apply tax on profits and then we calculate tax after that we add tax savings on capital allowances to that, however in this the examiner has done it differently as he has added capital allowances first then calculated tax, which method is right?
2.why in the present value of tax shield calculation the examiner has taken only the figure above or below the yield rate, like he has taken 150 basis points 0.0150 and not 2.5 +0.0150
thanks alot
1. The examiner has not added capital allowances!!!
There are two ways of dealing with tax which both give the same answer.
One way (which is usually the quickest) is to calculate the tax on the profits before capital allowances, and then to calculate the tax saving on allowances.
(For example, suppose profits before CA’s are 100; CA’s are 20; and tax is 30%. The cash flows are:
Profits 100
Tax on profit (30)
Tax saving on CA’s 6 (30% x 20)Net cash flow 76
The other way is to calculate the tax simply on the profit after allowances (as happens in real life).
So for the same example:
The tax payable = (100 – 20) x 30% = 24So net cash flow = 100 – 24 = 76
The examiner has used the second way in this example, but either way is fine and the answer is the same.
2. The examiner has not taken only the figures above or below the base rate.
Note (v) in the question says that the normal borrowing rate is 150 points over the govt yield rate. The govt yield rate is 2.5% (in the second to last paragraph), so their cost of borrowing is 2.5% + 1.5% = 4%
Part of the borrowing is a subsidised loan at 100 points below the govt yield rate, so the cost of that part is 2.5% – 1% = 1.5%oh ok sir,so in calculating the pv of tax shield we will multiply with 4% and 1.5% to get interest and calculate savings and then annuity factor right?
sir, how to calculate the issue cost? why the issue cost of 2% is divide with 98? ie (2/98)x $42.97m.
second, why in calculating the PV of tax relief, the answer is using 4% as the discount factor?
thank you 🙂
For every 100 raised (the gross finance), issue costs will be 2, which leaves 98 actually available to invest.
Therefore the issue costs are 2/98 times the amount needed to invest.Note (v) of the question says that the borrowing rate is 150 basis points (i.e. 1.5%) more than the 10 year government yield rate. The government yield rate is given as 2.5%.
2.5% + 1.5% = 4%.
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