Suppose a project financed via an issue of debt requires five annual interest payments of $10 million each year. If the tax rate is 30% and the cost of debt is 6%, what is the value of the interest rate tax shield?
A)$13.20 million
B)$11.35 million
C)$12.64 million
D)$12.21 million

Question

Quizplus · Accepted Answer

The value of the interest rate tax shield can be calculated using the formula:

Interest rate tax shield = tax rate x interest expense

where interest expense = cost of debt x debt

In this case, the debt is the total interest payments over the five years:

Debt = $10 million x 5 = $50 million

Therefore, the interest expense is:

Interest expense = 6% x $50 million = $3 million per year

And the interest rate tax shield is:

Interest rate tax shield = 30% x $3 million = $0.9 million per year

Over five years, the total value of the interest rate tax shield is:

Total interest rate tax shield = $0.9 million x 5 = $4.5 million

So the present value of the interest rate tax shield, using a discount rate of 6%, is:

Present value of interest rate tax shield = $4.5 million / (1 + 6%)^1 + $4.5 million / (1 + 6%)^2 + ... + $4.5 million / (1 + 6%)^5
= $4.5 million / 1.06 + $4.5 million / 1.1236 + ... + $4.5 million / 1.3382
= $3.93 million + $3.99 million + ... + $2.91 million
= $12.64 million

Suppose a Project Financed Via an Issue of Debt Requires