A 3-year project will cost $180 at the end of year 1 and is expected to produce operating profit before depreciation and amortization (EBITDA)of $80 in year 1, $100 in year 2, and $60 in year 3. Depreciation, both real and financial, will be calculated using straight-line depreciation over 3 years. The cost of capital is 10%, and the firm's marginal tax rate is 25%.
-Refer to the information above. Assume the firm will issue $100 of debt in year 1 with an expected interest rate of 8%. Interest must be paid each of the 3 years, and the principal is
Repaid at the end of year 3. What is the present value of the tax savings?

Question

Quizplus · Accepted Answer

The present value of the tax savings from the interest payments can be calculated using the interest tax shield formula, which is the interest payment multiplied by the tax rate, and then finding the present value of these savings. The annual interest payment is $100 * 8% = $8. The tax savings each year is $8 * 25% = $2. To find the present value, we discount these savings back at the cost of capital rate (10%) for each of the three years. The present value of tax savings = $2 / (1+0.10)^1 + $2 / (1+0.10)^2 + $2 / (1+0.10)^3 = $1.82 + $1.65 + $1.50 = $4.97. However, the correct calculation should account for the fact that the question asks for the present value of the tax shield, and the provided calculation mistakenly leads to the answer for option B. The correct approach involves recognizing the error in the explanation that aligns with option B's result rather than the intended correct methodology for calculating the present value of the tax shield on debt interest, which involves discounting the tax savings due to interest payments at the cost of capital. Given the error in the explanation, the correct answer should reflect the proper calculation of the present value of tax savings from the debt's interest payments, considering the tax rate and the discounting process over the period the interest is paid.

A 3-Year Project Will Cost $180 at the End of Year