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Hi John,
Just a slight confusion on the answer for the financing side effects, specifically the treatment of the subsidised loan. I don’t understand the need for the second part where they calculate the savings from the Subsidised loan. Surely this is already included above as USD5m was calculated at 8% interest, and then the USD4m loan was calculated with 6% interest (ie 2% saving)?
I would understand if the subsidy amount has initially been treated at an 8% interest, and so we need to recognise the saving, but it hasn’t.
Thank you in advance
I’ve just looked at this again, and I understand that we split up tax relief savings from interest payments and the interest costs of debt (please confirm if correct). If so, why do we not incorporate the interest costs on both sets of debt and minus this out from the NPV?
I assume you are happy with the first bit of the calculation – the actual tax they are saving on the actual interest that is paid.
As far as the subsidised loan ls concerned, suppose for a moment that there was no subsidy, and therefore the interest was at 8%. In that case they would be paying interest on the $4M of 320,000 and would have been saving tax (at 30%) of 96,000.
Because of the subsidy, they are only paying interest of 240,000 and only saving tax of 72,000.
Therefore the net saving due to the subsidy is 80,000 (saved interest) less 24,000 (tax not saved), which is 56,000.Sorry for adding to this post after 3 years, but i still do have some doubts about your answer.
First you are contradicting your statement made in this topic: https://opentuition.com/topic/apv-subsidy-benefit/
In this you have told the tax relief on actual interest has already been paid so the tax relief lost on subsidized loan shouldn’t be taken. And so i doubt why you are ignoring this here.And if you are right about this i feel like you will account for the tax lost twice.
My thought process goes like this and it can be confusing but please clear this doubt for me.So according to you Interest on 4M should have been 320,000 with a tax saving of 96000. But because of using the subsidized loan we only need to pay 240,000 as interest which will give 72,000 tax saving.
So by taking the subsidized loan we are saving 80,000 as interest and 24,000 tax saving lost and therefore a net saving of 56,000.In the end we are saving 120,000(5,000,000*.08*.3) tax on the normal loan, 72,000 on the subsidized loan and a tax saving loss of 24,000.
Adding all 120,000+72,000-24,000 = 168,000 of tax is saved.
The max tax saving could theoretically be 9,00,000*.08*.3=216,000.
So base on the above to the tax lost is 216,000-168,000= 48,000 which is 2 times that of tax saving lost.
If the tax saving lost has not been accounted then the it will become 216,000 – 192,000= 24,000 which is the actual tax saving lost.I know there is a lot of numerical in this but i can only prove my point this way.
And my point is if we are accounting the tax saved on actual interest then while calculating we doesn’t need to account for the tax saving lost cause we have already accounted that in our calculation.I take your point, but this was the examiners answer. However this is an extremely old question and the examiner has changed twice since this question was asked.
The current examiners sets the workings out differently as you will see if you attempt more recent questions from your Revision Kit.I was just doing FUBUKI CO (DEC 10). This one is a 10 year old paper compared to the 20 year year old paper we were discussing right now.
In this question too while doing the APV we account for the actual interest and then find their tax benefit. After that while doing the subsidized loan we take the interest saved + the tax saving lost.
I still haven’t figure out why we are deducting the tax saving when the tax part of subsidized loan is never part of the picture.
I have done many questions based on APV but all of them does the way i am not able to understand. So i have come to the conclusion that my logic might be wrong. But i am not satisfied with the reason behind it.
One more thing i wanted to ask you is that the reason behind we taking tax benefit of interest and not the interest itself(as this will also be a financing element) is that while calculating the base case NPV we have already accounted for the normal interest in the discount rate? Is this logic right?
Thank you for the quick reply.
APV is using Modigliani and Millers theory.
If there was not tax then the WACC would be the same whatever the level of gearing and so we would be equal to the cost of equity if there was no gearing at all. The base case NPV is the NPV discounting at the unguarded cost of equity.
When there is tax then there is the additional benefit of the tax shield when there is gearing i.e. the tax saved on the interest payments. For that reason (and only that reason) M&M state that a company should be as highly geared as possible.
So we take the base case NPV (i.e. as though no gearing) and then add on the PV of the tax benefit of the interest payments in order to get the adjusted present value.
Have you watched my free lectures on this?
I did watch your video lectures and i got the M&M theory.
I have read somewhere that the reason behind us not taking the interest is because it is accounted in the discounting rate. So subtracting the interest will be wrong. And i get that point.
When we use APV, just like the NPV we don’t subtract the interest itself but the interest saved in the process. So i am thinking like where does the interest is accounted for. Is it the discounting used while calculating the base case NPV or is it accounted in the discounting of financial impact or a combination of both.
I thought that when we use the base case NPV, we use the ungeared cost of Equity as there is no gearing impact. But as we are also adding the risk free rate of return in the CAPM model then we might be also accounting for the risk free interest rate in it. So in the base case NPV when we use the ungeared cost of equity we might be also taking into the risk free rate of return. That’s how my thought process goes
I just want to get clarity that in which discounting rate the interest is accounted for.
When we are discount at the WACC then we are accounting for the interest in the discount rate.
With APV we are discounting at the cost of equity if the company were all equity financed, and therefore there is no interest to be concerned with in the calculation of the base case NPV. The only affect of there being gearing in the company is that the company saves tax on the interest and that saving is added to the base car NPV.
Using CAPM to get the cost of equity if the company is all equity financed is accounting for the purchases business risk of the company. The fact that we add the risk free rate in the calculation of the cost of equity is nothing to do with accounting for interest, it is simply that the more the business risk in the company then the higher the required return will be above the risk free rate.
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