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

Brennan Co finances a project with $4 million of five-year, interest-only debt at 5% before tax. The debt is repaid at the end of year 5 and the tax rate is 30%. Tax shields arise at the end of each year and are discounted at the pre-tax cost of debt. The five-year annuity factor at 5% is 4.329 and at 10% is 3.791. What is the PV of the tax shield?

The PV of the tax shield is $259,740. The annual shield is $4m × 5% × 30%, which is $60,000, and this is discounted for five years using the 4.329 annuity factor at the 5% pre-tax cost of debt.

  1. A$259,740Correct
  2. B$300,000
  3. C$227,460
  4. D$865,800

Explanation

Annual shield = $4m × 5% × 30% = $60,000. PV = $60,000 × 4.329 = $259,740. $300,000 is undiscounted. $227,460 wrongly uses a 10% factor. $865,800 ignores the tax rate (uses $200,000 of interest).

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