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

Harrow Ltd is considering a project costing $2,000,000 now and giving after-tax operating cash flows of $500,000 a year for 5 years. The ungeared cost of equity is 10%. The project will be partly financed by a $1,000,000 bond at 6% interest, which stays outstanding for the five years. Corporate tax is 25%, and the tax shield is discounted at the 6% cost of debt. Annuity factors for 5 years: 10% = 3.791; 6% = 4.212. Ignoring issue costs, what is the APV?

The APV is negative $41,320. The base-case NPV at 10% is −$104,500, and the PV of the interest tax shield, $15,000 a year discounted at 6%, is $63,180. The financing benefit does not offset the negative base case, so the project should be rejected.

  1. A-$41,320Correct
  2. B-$47,635
  3. C-$104,500
  4. D+$148,220

Explanation

Base case NPV = 500,000 × 3.791 − 2,000,000 = −104,500. Annual tax shield = 1,000,000 × 6% × 25% = 15,000; PV at 6% = 15,000 × 4.212 = 63,180. APV = −104,500 + 63,180 = −41,320. Discounting the shield at 10% gives −47,635, which uses the wrong rate.

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