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Hi,
I’m not completely certain in my mind about the rules relating to which discount rate to use in an NPV question.
For example, in the question called ASOP, from the December 2009 exam, for part (a) they ask “based on financing cash flows only, calculate and determine whether ASOP Co should lease or buy the new technology”. The answer indicates that the pre tax loan interest rate should be used as the discount factor.
For question (b), they ask for the NPV of buying the new technology, and the answer indicates that they use the after tax WAAC as the discount factor.
Therefore, would I be correct in saying the pre tax cash flows should use a pre tax discount factor, and after tax cash flows an after tax discount factor?
Thanks for your help.
No.
It is a problem specific to lease and buy questions.
In choosing between leasing and buying, discount at the pre-tax loan interest rate.
For deciding whether a project is worthwhile, use the after tax WACC.
Sorry to come back again, but from looking at other exam paper answers, I still don’t feel I understand properly yet.
You said the use of the pre-tax discount rate is specific to lease/buy decisions. Yet, in the question called “Ridag Co” from the June 2006 paper, part (a) requires the use of the after-tax weighted average cost of capital of 7%, and part (b) requires use of the before-tax average cost of capital of 12% (according to the answers). This is not a lease/buy decision. I should point out that the cash flows in part (a) are after-tax, and the cash flows in part (b) are before-tax.
In the notes prior to the answers it writes “for part (a), since we have nominal after-tax cash flows, the nominal after-tax WACC should be used – ‘discount like with like’. “
“part (b) states that taxation had to be ignored. Again applying the right discount rate is important: you should discount nominal before-tax cash flows with the nominal before-tax WACC”.
Is there a rule I should know about? Thanks again.
You mean June 2012 (not 2006) 🙂
The only rule is the one I gave you in the last reply.
The only reason that part (b) use the before tax cash flows and the before tax WACC is because the questions specifically said to ignore tax for this part.
(and the only reason the examiner did that is because bringing in tax would have made this part of the question unnecessarily
complicated – in practice we certainly would not ignore tax)You always discount the after tax cash flows at the after tax WACC to appraise an investment unless you are specifically told different in the question.
(the lease/buy decision is a separate thing – it is not actually appraising the project)Sorry, you’re right, I meant June 2012!
I probably phrased my question very badly, but I think I’ve got it now. Basically, although the question tells me to ignore tax in part (b), I knew to ignore tax when preparing the cash flows, but I didn’t know I also had to use the pre-tax discount rate, until now. I would have always used the after-tax WACC prior to now.
Thanks again for explaining it to me. I’m getting there, slowly!
@johnmoffat said:
No.It is a problem specific to lease and buy questions.
In choosing between leasing and buying, discount at the pre-tax loan interest rate.
For deciding whether a project is worthwhile, use the after tax WACC.
Here is where I saw it sir that pre-tax rate was allowed but it’s 4years back now.
It was a typing error on my part – what is in the lectures notes and my lectures is correct 🙂
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