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

Dalby Co will finance a new project partly with debt, but it has tax losses brought forward that will remove its taxable profits for the first two years. Which statement about the interest tax shield in the APV is correct?

The shield should be valued only from the years when interest relief actually reduces tax payable, so its present value is lower. Tax relief on interest has value only if there are taxable profits to set it against. Delays therefore reduce the APV.

  1. AThe shield should be valued only from the years in which interest relief actually reduces tax payable, so its present value is lowerCorrect
  2. BThe shield should be valued from year 1 regardless, because interest is paid from year 1
  3. CThe shield should be ignored altogether, because tax relief on interest only matters in a WACC calculation
  4. DThe shield should be discounted at the ungeared cost of equity so that the tax losses are allowed for

Explanation

A tax shield exists only when interest reduces tax actually payable. With no taxable profits in years 1–2, relief is delayed (or lost), so the shield should be timed from when it is used. Its present value is therefore lower. Ignoring the shield is wrong because APV explicitly values it, and changing the discount rate does not deal with timing.

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