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John Moffat.
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Olya
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Dear John Moffet!
Thanks again and again for tutoring
My question is about this passage in Pilot paper (Tramont question #1) “It is assumed that the borrowing rate of 5% is used to calculate the benefits from the tax shield. It could be argued that the risk
free rate of 3% could be used as the discount rate instead of 5% to calculate the present value of benefits from the tax shields
and the subsidies. ”
why it is mentioned about risk -free rate? I mean when risk -free rate should be better than specific to company ? Or it is somehow because we assume that debt is risk free?
And one more question please. BPP extends the answer to debt capacity. They tell that APV apply to all debt capacity of the company. I thought the part of debt used for the project.thank you very much
John Moffat
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With regard to the interest rate to use for the calculation of the benefits of tax shield, then there are arguments for using either 5% or 3%. The rate used should be the rate applicable to the risk associated with the tax benefits. Some would argue that the benefits are risk free (hence 3%) whereas others argue that they carry the same risk as the debt itself (hence 5%). (APV is effectively using Modigliani and Millers theories and they assume debt is risk free in their work).
Because it is arguable, the examiner always accepts discounting at either rate.
With regard to your second question, when calculating the tax benefit we should calculate it on the increase in the debt capacity resulting from doing the project rather than just on the debt actually raised at that point. However, as BPP have written (and their answer is simply a copy of the examiners answer) since there is no mention of the debt capacity in the question, they have just used the debt actually raised.
Most importantly in the exam you must always state your assumptions (and that it why question 1 always specifically asks you to state your assumptions). There is never one correct answer at P4 – it depends on your assumptions, and provided you have stated them and that they are reasonable, you will still get the marks (even if your answer differs from the ‘model’ answer).
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