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

Bexley Co is appraising a project costing $10m now. It will give after-tax operating cash flows of $3.2m a year for 5 years. The ungeared cost of equity is 10%. The project will be partly financed by $4m of five-year debt at 6% a year (interest only, repaid at the end). The tax rate is 25%, and the tax shield is discounted at 6%. Annuity factors for 5 years: 10% = 3.791, 6% = 4.212. What is the APV?

The APV is $2.384m. The base-case NPV is $2.131m (3.2m × 3.791 less 10m). The tax shield is 0.06m a year, worth $0.253m at 6% over five years. Adding the two gives the APV.

  1. A$2.384mCorrect
  2. B$2.359m
  3. C$3.142m
  4. D$2.131m

Explanation

Base-case NPV = 3.2 × 3.791 − 10 = 2.131m. Annual tax shield = 4 × 6% × 25% = 0.06m; PV at 6% = 0.06 × 4.212 = 0.253m. APV = 2.131 + 0.253 = 2.384m. Discounting the shield at 10% gives 2.359m, which is wrong because the shield has debt-like risk. Using the pre-tax interest of 0.24m gives 3.142m, which ignores the tax rate.

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