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Hi John,
Could you please explain why in the calculation of APV we don’t include the cashflow of the interest payment?
1) step 1: operating cashflow discounted using ungeared ke ( I understand this)
2) step 2: deduct issue cost, adding tax shield on interest paid on the loan
If we don’t include the cashflow of the interest payment in step 2 , isn’t the whole APV gonna be overvalued? Please help me to understand ideally with a numerical example.
Many thanks,You will remember (from Paper FM) that according to Modigliani and Miller then in the absence of tax the total MV of a company stays the same regardless of the level of gearing. They also show that if there is company tax then the MV increases with more gearing and that this increase is solely because of the tax saving that is made on the interest payments. APV is just applying this idea.
I do explain this (with examples) in my free lectures on APV.
Hi there, I have come across a question where part of the investment was financed by a bank loan and part of it by a subsidised loan.
The question read as following:
”The finance director has proposed the following finance package for the new investment:$200m Bank loan, repayable in equal annual instalments over the project’s life,
interest payable at 6% per year
£300m Subsidised loan from a government loan scheme over the project’s life
on which interest is payable at 2.5%Issue costs of 2% of gross proceeds will be payable on the subsidised loan. No issue costs will be payable on the bank loan. Issue costs are not allowable for tax.”
Subsidised loan benefit calculation included:
1. Tax benefit $300m × 2.5% × 20% × AF(6%, 4) = $5.20m
2. Subsidy benefit: $300m × (6% ?-2.5%) × (1 – 20%) × AF(6%, 4) = $29.11m
3. Issue costsI am struggling to understand the logic behind the 2nd working. Could you explain this working step by step please?
Thank you,
NGiven that the interest on the bank loan is 6%, this is treated as the ‘normal’ rate of interest and therefore the benefit of the subsidy is 6 – 2.5 = 3.5%.
Presumably the tax rate is given in the question as being 20% and so the net benefit of the subsidy is only the remaining 80% of the interest saving.
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