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

A finance director argues that an interest tax shield should be discounted at the cost of debt in an APV calculation. Which statement best supports this?

The tax shield is discounted at the cost of debt because it arises from contractual interest payments, so its risk is similar to that of the debt, assuming the firm has sufficient taxable profits to use the relief.

  1. AThe tax shield is as risky as the project's operating cash flows
  2. BThe tax saving depends on the company paying interest and having taxable profits, so its risk is similar to that of the debtCorrect
  3. CThe tax shield is certain and so should be discounted at the risk-free rate only
  4. DThe tax shield is financed by equity and so uses the cost of equity

Explanation

The tax shield arises from contractual interest payments, so its risk is similar to that of the debt, provided the company has enough taxable profit. It is not as risky as operating cash flows. The risk-free rate is used only where the tax saving is regarded as certain, which is a different assumption.

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