PV of Subsidy Example

Joshy Jacob, IIMA

February 24, 2015

Debt swap example in the class

The following reproduces the example which have started to build-up in the last session and
completes the discussion of the estimation of the PV of subsidized debt.
A perpetual rm has assets of 1000 million, rA = 12%1 , EBIT 200 million, Tax 40%, and its
regular cost of borrowing is 10%. The value of unlevered rm is 1000 million (perpetual FCF of
120 million discounted at 12%). When the rm borrows 400 million at its regular cost of debt
10%, it earns a P V (IT S) of 160 million. Hence the value of the rm goes up by 160 million on
leverage. We have started to discuss the impact of the replacement of 200 million of the regular
debt at 10% with 200 million subsidized debt at 5%. These calculations are given below:
All equity

400 Debt at 10%

200 Debt at 10%,

200 Debt at 5%

1000
1000
0
200

1000
600
400
200

1000
600
400
200

40

20
10
120
1000
12
0

Assets
Equity
Debt
EBIT
Interest:
Regular
Subsidized
F CF = EBIT (1 T )
VU

ITS
PV(ITS)
PV of subsidy
VL

120
1000
16
0
0
1160

120
1000
0
0
0
1000

1120

When we evaluate the levered rm's value as VL = VU + P V (IT S), the replacement of regular
loan at 10% with subsidized loan at 5% leads to a loss interest tax shelter of 4 million per year
and therefore leads to loss of rm value of 40 million. However, we know that the lower interest
is value adding to shareholders and therefore, it is valuable to the rm (this of a zero interest
loan). This is not reected in the two part valuation approach presented above. Hence, we
need to estimate the value of the lower interest to the shareholders. This can be worked out as
follows.
It is evident that the 200 million subsidized debt allows the rm to save interest outows of 10
million every year before tax (6 million after tax) compared to borrowing at the regular cost.
The 10 million saved every year could allow the rm to borrow an additional 100 million regular
debt. This borrowing does not aect the cashows of the rm as the interest outow of 400
million regular debt at 10% is equal to the interest outow of 300 million regular debt at 10%
and 200 million subsidized debt at 5%. Assuming that all the assets of the rm are fully funded,
this leads to an excess cash of 100 million in the rm relative to borrowing 400 million at the
regular rate. This excess cash, therefore, can be paid out as dividend to shareholders. Hence the
1

In Section C, we had used r of 10%.

A

value of the subsidized borrowing is 100 million. How do we estimate it formally? The following
discussion develops the logic required for this valuation.

Estimation of subsidy value

Let us imagine that someone lends 100 to you at 5% interest rate for one year. The borrowed
amount needs to be repaid along with interest at the end of a year. You can lend it at 10%.
There are no taxes.
This is a valuable opportunity as reected in the 10 that can be earned in a year compared to
the interest of 5 to be paid in a year.
How much is this worth? It depends on the PV that needs to be deposited (at time t = 0) to
meet your obligation of the repayment of 105 (100 + 5 interest) in one year (t = 1).
Given your lending opportunity at 10%, the amount needs to be deposited to meet the time
t = 1 obligation of 105 is:
105
= 95.45 rounded
1 + 10%

Hence, at t = 0, you can borrow 100, deposit 95.45 to meet your obligation and be better o by
+100 95.45 = 4.55. This is the value of the subsidy. This dierence is the NPV of the loan:
100

105
= 4.55
1 + 10%

If the rm faces 40% tax rates, how much needs to be deposited to meet the same obligation

of 105 at time t = 1.
We know that as the interest is taxed, we receive only 6 after the taxes from depositing the
money. At the same time, the payment of interest on after-tax basis is only 3.0. Therefore the
liability falls to 103. The amount of money that needs to be deposited to earn 103 at time t = 1
at 6% after-tax basis is:
100 + 5 (1 40%)
103
=
= 97.17
1 + 10% (1 40%)
1 + 6%

Hence, by the borrowing of 100 (at 5%) and depositing 97.17 at t = 0 to meet the obligation,
we are better o by 2.83. This is the NPV of the one-year loan as follows:

+100

103
= 2.83
1 + 6%

Therefore, the discounting rates for the subsidy estimation would always be on after-tax basis.
This is eectively a debt swap by the rm.
Alternatively, the loan NPV above can be estimated, by just nding the PV of the incremental
cash ows of the two borrowings, the one at 10% and the subsidized at 5%. When you switch
2

from the regular borrowing to the subsidized borrowing here, you save 3 (6 - 3) in a year. What is
the value of this savings? Again, how much needs to be deposited to pay o 3 one year from now?
Given, 6% after-tax yield from your lending opportunity, this just becomes 2.83 (PV of 3 at 6%).
Now let us come back to the replacement of regular debt by subsidized debt. It can be easily
seen that NPV of the subsidized loan is 100 million worked out as follows:
PV of cash ows at time t = 0 (borrowing)

200

Before-tax interest outows (t=1 to )

-10
After-tax interest outows
-6
PV of interest outows at the after-tax cost of regular debt (6%) -100
NPV of the loan (200 100)
100
Of course, when you switch from a regular loan to a subsidized loan, there is a loss of tax shelter
as well. This need to be deducted from the Subsidy to get the net impact on the rm. In the
context of replacement of the regular loan with subsidized loan they work out as follows:
Loss of interest tax shelter

-40

PV of after-tax interest saved

100
Net impact of the subsidized loan of 200 million 60
The value of the rm then would be VU +P V (IT S)+Value of interest subsidy = 1000+120+100.
This is the estimate to be done in Southport. The two subsidized loans are each at 7% interest
rate. The regular cost of borrowing is 11%. The value of subsidy in Southport can be estimated directly by nding the NPV of the subsidized loans (after-tax cash ows of the two loans
discounted at after-tax cost of regular loan of 11% (1 40%)).