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

Aldana Ltd is appraising a project costing $8 million. Using the APV method, it assumes the project supports debt equal to 30% of the initial investment. The debt is perpetual and costs 6% before tax, and the corporate tax rate is 25%. What is the present value of the tax shield on interest, discounting at the pre-tax cost of debt?

The PV of the tax shield is $600,000. Debt capacity is 30% of $8m, or $2.4m, and for perpetual debt discounted at the cost of debt the PV of the shield equals debt multiplied by the 25% tax rate.

  1. A$600,000Correct
  2. B$2,000,000
  3. C$36,000
  4. D$1,800,000

Explanation

Debt capacity = 30% × $8m = $2.4m. For perpetual debt discounted at the cost of debt, PV of the tax shield = debt × tax rate = $2.4m × 25% = $600,000. Using the full $8m cost gives $2m, which ignores the debt capacity limit. $36,000 is only one year of shield ($2.4m × 6% × 25%).

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