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Hi,
I have several questions about APV1. APV= Base NPV+ tax sheild+ subsidy interest saving -issue cost + issue cost tax effect(if allowable for tax)+ spare capacity tax effect
I’m not sure if this equation is right.
2. subsidy actually have a tax effect, have this already included in the calculating of tax sheild? (we use the company lower rate)
3. why some question includes issue cost in the total debt investment to calculate tax sheild? I thought issue cost should be treated seperately and only be discounted for one year if tax is paid in one year. Some question just use debt+issue cost to calculate tax sheild for every year and discount them every year. But issue cost only happens when debt is issued.
1 is correct
2 Yes, and so you should reduce the subsidy by the tax rate
3 It very much depends on the wording of the question (and also on assumptions, which you must always state).
Obviously, issue costs have to be paid whatever happens. The problem is whether they are paid out of the proceeds of the issue (in which case we need to gross up to get the amount issued, and we calculate the interest on this amount), or whether the issue costs are paid out of retained earnings (in which case the debt does not need grossing up and the interest is therefore on the same amount as is invested).
If it is not made clear by the wording, then do either – but do state what you have assumed.
Sir,
Thank you for the explaination.
But about point 3, I think you misunderstood my question. Let me take a example.
Say the debt is 800, issue cost is 100, interest rate is 5% and tax rate is 30%. We have a period of 4 years.
When calculating tax shield, some question use 900*0.05*0.3 to get tax saving for every year of total 4 years and discount every year.
Other question just use 800*0.05*0.3 to calculate tax sheild and discount that 4 year cash flow and then calculate tax effect of issue cost separately and only discount it for 1 year.Personally I think the second treatment is right. Because issue cost only have one year effect on tax and the first treatment use issue cost for four years which doesnt make sense.
Can you explain that please?
I slightly misunderstood, but also I think you misunderstood me 🙂
You say that the debt is 800.
However, if it is that 800 is needed for the investment and that the issue costs of 100 are paid out of the finance raised, then that would mean that the finance raised would be 900 and therefore there would be interest based on the 900.
If, on the other hand, the issue costs were paid out of retained earnings, then to invest 800 would only mean that they needed to raise 800 from debt, and therefore the interest would be based on only 800.
Usually the wording of the question makes it clear what the position is. But if not, then it is an assumption and provided you state the assumption (and do the workings correctly on that assumption) then you will get the marks.
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