Advanced Financial Management · Impact of financing on investment decisions and adjusted present values

Financing Side Effects in APV: Tax Shield and Issue Costs

Updated 11 October 2026 · Fact-checked

Financing side effects are the value changes caused by how a project is funded. In APV you add them to the base-case NPV. The main ones are the present value of the debt tax shield, issue costs (a negative), and the benefit of subsidised loans. Discount each at a rate that matches its risk.

Understand Financing Side Effects: Tax Shield and Issue Costs

Adjusted present value (APV) splits a project into two parts. First you value the project as if it were funded only by equity. This is the base-case NPV, discounted at the ungeared cost of equity. Then you add the value created or lost by the way the project is financed. These are the financing side effects.

The most common side effect is the tax shield on debt interest. Interest is tax deductible, so each year of interest saves tax of interest × tax rate. That saving is real value created by using debt. You only count it for the debt the project actually supports, and only if the company has enough taxable profit to use the relief.

Issue costs work the other way. Raising finance costs money: underwriting, legal and advertising fees. They are usually quoted as a percentage of the gross amount raised, so you must gross up. If the project needs a net sum, the gross amount is net needed ÷ (1 − issue cost %). Issue costs are paid at the start, so they are not discounted. If they are tax deductible, reduce them by the tax saved.

Subsidised loans are loans at below-market rates, often from a government. The benefit is the difference between the loan amount and the present value of what you actually pay (after-tax interest and repayment), discounted at the rate the company would pay on a normal commercial loan. Other side effects include tax-relief limits, and the cost of financial distress, which you would normally treat qualitatively.

The key skill is the discount rate. The base case uses the ungeared cost of equity. The tax shield is usually discounted at the pre-tax cost of debt, because its risk is like that of the debt. Issue costs at time 0 need no discounting. A subsidised loan is discounted at the market pre-tax cost of debt. Always say which rate you use and why. The examiner rewards the reasoning.

Key rules to remember

APV: APV = Base-case NPV + PV of financing side effects; Base-case NPV uses the ungeared cost of equity and the project's operating cash flows only.
Annual tax shield: Tax shield = Interest × Tax rate = Debt × Interest rate × Tax rate; Use the interest on debt the project supports. Check when tax is paid and whether a tax cap or limit applies.
PV of tax shield: PV = Σ Tax shield ÷ (1 + Kd)^t; Usual discount rate is the pre-tax cost of debt. Use the rate the question tells you if it states one, such as the risk-free rate.
Gross finance raised: Gross amount = Net amount needed ÷ (1 − issue cost %); Issue costs are a percentage of the gross amount, not of the net amount.
Issue costs in APV: Issue costs = Gross amount × issue cost %; after-tax cost = Issue costs × (1 − tax rate) if deductible; Paid at time 0, so no discounting. Include as a negative.
Subsidised loan benefit: Benefit = Loan − PV of after-tax interest and repayment at the market pre-tax cost of debt; Equivalent to the PV of the interest saving plus the tax effect. Use the market rate as the discount rate.

How to solve Financing Side Effects: Tax Shield and Issue Costs questions

Use this order for any APV financing question. It keeps the marks for each side effect separate and easy for the marker to see.

1Read the requirement and identify the base-case NPV. Check whether it is given or you must calculate it at the ungeared cost of equity.
2List every financing source in the question: debt, equity, subsidised loan, and any issue costs.
3For each side effect, decide the amount, the timing and the tax treatment. Note the tax rate and when tax is paid.
4Calculate the annual tax shield as debt × interest rate × tax rate. Discount it over the loan term at the stated rate, usually pre-tax Kd. Use an annuity factor if the shield is level.
5Gross up issue costs if they are quoted on gross funds. Calculate the cost at time 0 and adjust for tax relief only if the question says they are deductible.
6For a subsidised loan, discount after-tax interest and repayment at the market pre-tax cost of debt. Subtract the total from the loan amount to get the benefit.
7Add all side effects to the base-case NPV to get the APV. Accept the project if the APV is positive.
8State your assumptions and give a short comment, for example on debt capacity, whether the tax relief can be used, and what the result means for the decision.

Quickest way: Three-line APV adjustment

When to use it: Use when the question gives base-case NPV (or it is quick to find) and asks for the APV with a few financing side effects. Time is short, so keep a fixed layout.

Write three lines: Base-case NPV, PV of tax shield, issue costs (and subsidy benefit if any).
Work out the gross finance first (net ÷ (1 − cost %)). Issue costs and interest both come from this figure.
Tax shield = gross debt × rate × tax; multiply by the annuity factor. Subsidy benefit = loan − PV of payments at market Kd.
Add up, then write one sentence on the decision and one on the discount rate you used.

Common mistakes in Financing Side Effects: Tax Shield and Issue Costs

Discounting the tax shield at the ungeared cost of equity or WACC.
Students use one rate for everything in APV.
Fix: Discount the tax shield at the pre-tax cost of debt unless the question tells you otherwise. Only the base-case cash flows use the ungeared cost of equity.
Calculating issue costs on the net amount needed instead of the gross amount raised.
Students forget that the fees come out of the money raised.
Fix: Gross up first: net needed ÷ (1 − issue cost %). Then apply the percentage to the gross figure.
Discounting issue costs, or forgetting the tax relief.
Students treat every financing item as a cash flow in the loan term.
Fix: Issue costs are paid at time 0, so no discounting. Reduce them by tax only when the question says they are deductible.
Computing the tax shield on the whole loan period without checking the term or the amount of debt.
Students rush and use the wrong years or the wrong debt figure, for example net instead of gross debt.
Fix: Underline the loan amount, rate and term. Use the gross debt actually raised and an annuity factor for exactly the loan term.
Valuing a subsidised loan at the subsidised rate.
Students discount the payments at the cheap rate, so the benefit looks like zero.
Fix: Discount at the market pre-tax cost of debt. The subsidy is the gap between the loan received and the lower present value of the payments.
Giving a number with no assumptions or comment.
Students focus on calculation marks only.
Fix: Add a short note on the rate, tax assumptions, and whether the company can use the tax relief. It earns professional skills and technical marks.

Worked examples

Example 1

A company is evaluating a project with a base-case NPV of $150,000, calculated at the ungeared cost of equity. The project needs $980,000, which will be raised entirely through a 4-year bond at 6% annual interest, with the principal repaid at the end. Issue costs are 2% of the gross amount raised and are not tax deductible. The tax rate is 25%, paid in the same year as the profit. Calculate the APV.

Show the solution

Gross debt = 980,000 ÷ (1 − 0.02) = 980,000 ÷ 0.98 = $1,000,000.
Issue costs = 2% × 1,000,000 = $20,000, paid at time 0 and not tax deductible, so the cost stays at $20,000.
Annual interest = 6% × 1,000,000 = $60,000. Annual tax shield = 60,000 × 25% = $15,000.
Discount the tax shield at the pre-tax cost of debt, 6%. Annuity factor for 4 years at 6% = (1 − 1.06^-4) ÷ 0.06 = 3.4651.
PV of tax shield = 15,000 × 3.4651 = $51,977.
APV = 150,000 + 51,977 − 20,000 = $181,977.

Answer: APV = $181,977. It is positive, so the project is acceptable. Debt adds about $51,977 of value through the tax shield, and issue costs take away $20,000.

Example 2

A project has a base-case NPV of −$30,000. A government agency offers a loan of $800,000 for 5 years at 2% annual interest, with the principal repaid at the end. The company's normal pre-tax borrowing rate is 6%. The tax rate is 25%. Calculate the APV, assuming the loan is available only if the project goes ahead and there are no issue costs.

Show the solution

After-tax annual interest = 800,000 × 2% × (1 − 0.25) = 16,000 × 0.75 = $12,000.
Discount at the market pre-tax cost of debt of 6%. Annuity factor for 5 years at 6% = 4.2124.
PV of after-tax interest = 12,000 × 4.2124 = $50,549.
Discount factor for year 5 at 6% = 1 ÷ 1.06^5 = 0.7473. PV of repayment = 800,000 × 0.7473 = $597,806.
Total PV of payments = 50,549 + 597,806 = $648,355.
Subsidy benefit = 800,000 − 648,355 = $151,645.
APV = −30,000 + 151,645 = $121,645.

Answer: APV = $121,645. The base-case NPV is negative, but the subsidised loan is worth enough to make the project acceptable. Note that the decision depends on the loan being tied to this project, so you should comment on that assumption.

Exam tips

Start every APV answer with a clear layout: base-case NPV, then each financing side effect on its own line, then the total. It makes the marks easy to find.
Read the question for the discount rate. If it names one for the tax shield (for example the risk-free rate), use it and say so. If not, use the pre-tax cost of debt and state your assumption.
Check whether issue costs are given on the gross amount or net, and whether they are deductible. This changes the answer and is a common trap.
Do not stop at the number. In Section A, add a short comment on tax capacity, debt capacity, and what a positive or negative APV means for the decision. This helps with your professional skills marks.
If the loan is subsidised, always show the market rate you used for discounting. A correct method with a wrong figure still earns method marks.

Practice questions from Impact of financing on investment decisions and adjusted present values

Financing Side Effects: Tax Shield and Issue Costs in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Actuarial Core Principles (IAI)Tax Effects on Financing and Capital Structure

Financing Side Effects: Tax Shield and Issue Costs: frequently asked questions

Which discount rate should I use for the tax shield in APV?

The usual answer in ACCA AFM is the pre-tax cost of debt, because the tax saving is about as risky as the interest payments. Some questions state the risk-free rate instead. Follow the question if it gives a rate, and state your reasoning.

Do I discount issue costs in APV?

No. Issue costs are paid when the finance is raised, at time 0, so they are already in present value terms. If they are tax deductible, reduce the cost by the tax saved. The tax relief timing follows the question's instructions.

How do I value a subsidised loan in APV?

Find the present value of the after-tax interest and the repayment, discounted at the market pre-tax cost of debt. Subtract this from the loan amount. The difference is the benefit of the subsidy, which you add to the base-case NPV.

Why must I gross up the finance raised?

Issue costs are a percentage of the total amount raised, and they come out of that amount. If you need a net sum, divide by (1 − issue cost %) to find the gross amount. Then calculate interest and issue costs on that gross figure.