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- This topic has 6 replies, 2 voices, and was last updated 1 year ago by John Moffat.

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- April 14, 2021 at 8:08 am #617579
Hi Mr John, could you please explain why with this method i dont receive the same answer

Cash flow

Year 1 – 4mln – 3.4 + 4.5= 5.1

Year 2 – 8mln – 3.4 +4.5 = 9.1

year 3- 16mln – 3.4+4.5= 17.1

…

we are taking a loan 3% means there is additional cost 4.5 and tax saving 1.1. Total from free cash flow we need to deduct 3.4, why in the question we consider only tax saving 1.1, what about additional cost 3.4, why not deducting from cash flow? why based on above calculation i got -21.5 (-150 investment +128.5(the calculation based on above method for whole years)

Loan 150mln 3% 4.5

Tax 25% 1.1

Interest cost after tax 3.4

Loan benefit 7%-3%=4% 6

Tax 25% 1.5

Saving 4.5April 14, 2021 at 8:49 am #617590In future you must ask in the Ask the Tutor Forum if you want me to answer – this forum is for students to help each other.

We are calculating the adjusted present value, and for APV calculations we always calculated the base case NPV as though the company is all equity financed. Separately we add on the benefit of the tax saving on any debt finance used because of Modigliani and Miller.

(Even in normal NPV calculations (i.e. not APV) we never bring in the interest as a cash flow because the whole point of discounting at the WACC is to account for the cost of finance – to include it in the cash flows as well would be accounting for it twice.)

I do suggest that you watch my free lectures on all of this 🙂

April 14, 2021 at 9:55 am #617602Noted Mr. John. sorry.

in the question it says government offered a loan, means company will take it. if company is fully equity financed, yes tax 1.1 should be added to free cash flow 4, however the same cash flow should be used to pay interest.

in your other answers it is also mentioned if we include interest and tax we account it twice , this part is not clear, may you please bring an example.

we also have saving 4% (7% is loan in the market government offered for 3%). why in this case we dont take only tax saving 1.5, instead we calculate interest 6, deducting tax 1.5, then consider 4.5. what is difference between this one and 1.1 only tax amount.

thank you for your support

April 14, 2021 at 10:20 am #617605the interesting part is Mr John that i am receiving the correct answer only with negative sign. if i am doing wrong why i am getting correct answer

Loan -150Year 1 – 4mln – 3.4 + 4.5= 5.1

Year 2 – 8mln – 3.4 +4.5 = 9.1

year 3- 16mln – 3.4+4.5= 17.1..

Year 15 21.2 mln- 3.4+4.5=22.3

——————————————

After discount – 128.5-150+128.5= -21.5

April 14, 2021 at 3:43 pm #617633We never ever include interest payments when arriving at the net cash flows that we then discount for the reasons I explained in my previous reply.

This is revision from Paper FM (was F9) and I explain it in my Paper FM lectures and revise it in my Paper AFM lectures.If the company were entirely equity financed (and therefore obviously no subsidised loan) the base case NPV would be 120.5 – 150 = -29.5

As I also explain in my free lectures on APV, according to M&M then if there were no tax then using debt would make no difference to the NPV because gearing is irrelevant without tax. When, as here, there is tax, then the gain (the NPV) will increase due to the tax shield i.e. the PV of the tax saving on the interest, which for this question is $1.1M per year for 15 years. When (as here) there is a subsided loan, then there is the additional benefit of the after-tax interest saving, which for this question is $4.5M per year for 15 years.

The PV of the tax saving and subsidy saving is $51.0M, and therefore the APV is -29.5 + 51.0 = $21.5M.The fact that you arrive at a negative figure similar to the correct positive answer is a complete coincidence. You have only discounted the tax saving on the interest but not the subsidy saving, and you have discounted it at 11% when they should both be discounted at the company’s normal borrowing rate of 7%.

Have you watched my free lectures on APV?

April 14, 2021 at 5:41 pm #617651Thank you very much Mr John for clarification.

1.The gearing with Tax benefit will save $1.1M tax per year- this is clear.

2. Subsided loan – i understand that instead of taking loan for 7% there is an option for 3%, difference is benefit – 4%. However confusion for me is – why for subsided loan we are not taking only tax 1.5 , as you said we never include interest why now we take interest ( as in point 1 – $1.1)?

Subsidy benefit (150mln*4%) = 6

Tax 25% =1.5

After tax benefit = 4.53. During calculation of APV- cash flow discounted by WACC 11%, while tax saving and subsided loan discounted by 7% which is debt interest rate, while in the question there is a risk free rate available, why we dont take it?

4. To include it in the cash flows as well would be accounting for it twice – your answer

i am taking Loan less tax. please explain what does it mean accounted twice , where?5. please find the link of video which i watch for APV. please guide me if not on the right way

https://opentuition.com/acca/afm/the-impact-of-financing-part-2-acca-afm-lectures/Thank you once again for your time and support

April 15, 2021 at 9:26 am #617708I did not say that we never include interest. In the calculation of the base case NPV we do not include interest flows. However to get the APV we add on the PV of the tax saving resulting from the interest. When there is a subsidised loan there is an extra benefit of the PV of the interest saved (net of tax).

As I explain in my lectures, the PV of the tax shield and the benefit of the subsidy can be arrived at by. discounting either at the risk free rate or at the normal cost of borrowing. There are arguments for both and as a result the examiner always accepts either (even though obviously the final answer is different).

I have already explained why we never include interest flows when arriving that the NPV (and it was the same for Paper MA and for Paper FM). The whole purpose of discounting is to account for the cost of capital and the calculation of the WACC includes the cost of the debt finance. (In APV that is not relevant anyway because the base case NPV is calculated on the assumption that the company is entirely equity financed and therefore there is no interest anyway.)

The link is to the correct lecture, although it does not make much sense to watch lectures at random – they are a complete course and all are intended to be watched in the chapter order.

Given that it seems you had not previously watched the lecture, I assume you had already studied APV from a Study Text before attempting this question?

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