PDA

View Full Version : C2: may2001#24

shluffer
10-28-2002, 04:57 PM
A company has an asset with a depretiation basis of 100,000 which can be depretiated by the folowing schedule:
YEAR PERCENT
1 33.33
2 44.45
3 14.81
4 7.41

The marginal tax rate is 35% and the pretax borrowing rate is 12%.

Calculate the NPV

Answer is 30268.

The tax shield is the amount of depretiation * the tax rate, then you just discount. Prob is, do you discount by the pretax interest rate or the post tax interest rate? I have seen this questoin done both ways. Here they want the post tax interest rate. How do I look at this problem and know that?
Avi
10-28-2002, 05:03 PM
Depreciation Shields are discounted by the POST tax rate (1-T<sub>c</sub>)*r<sub>D</sub>. Interest Shields are discounted by the pre-tax rate r<sub>D</sub>.

I don't fully understand it either, but it has something to do with the fact that the borrowing rate ITSELF knows that interest is tax deductible so the fact that r<sub>D</sub> &lt; r<sub>E</sub> has that nuilt into it. Depreciation shields are not included in that, and since they are pretty certain, can be discounted by (1-T<sub>c</sub>)*r<sub>D</sub>.

--Avi

:roll:
retaker
10-28-2002, 05:51 PM
I believe it is always supposed to be the after tax rate in this situation. What problem did you see where this wasn't the case?????

Brealy and Meyers state. "Discount safe after tax flows, at the after-tax borrowing rate."

You do this for the PV of depreciation tax shields and PV of loans.

Oh, and by the way, I never figured this out either. I asked the seminar instructor and never got an answer I was satisfied with.

Also, you don't always discount interest tax shields at r_d.
Avi
10-28-2002, 06:02 PM
I believe it is always supposed to be the after tax rate in this situation. What problem did you see where this wasn't the case?????

Brealy and Meyers state. "Discount safe after tax flows, at the after-tax borrowing rate."

You do this for the PV of depreciation tax shields and PV of loans.

Oh, and by the way, I never figured this out either. I asked the seminar instructor and never got an answer I was satisfied with.

Also, you don't always discount interest tax shields at r_d.

Agreed on the last point.

You can find the differentiation in HTP page 178, and more importantly Brealy and myers Chapter 19.4 (pages 564-566)

--Avi